One common way venture capital (VC) investors seek to protect their investments is called a liquidation preference. Such a liquidation preference, however, can impact the exit outcomes for founders and early stage employees. If you are considering participating in a VC financing round, as investor or startup, consider discussing the potential implications of any liquidation preferences with a VC lawyer from Priori Legal.
Understanding Liquidation Preferences
When VC investors agree to inject capital into a business, they seek to structure the investment to maximize the chances of a lucrative exit from the investment (commonly referred to as return on investment or ROI). Because liquidation preferences are paid out before other equity interests, liquidation preferences increase the likelihood that an investor can recoup some of their investment when a company is sold, acquired, merges with another company, or is liquidated through bankruptcy or dissolution.
Preferred Stock vs. Common Stock
Mechanically, liquidation preferences are a feature of preferred stock. Investors holding preferred stock with a liquidation preference feature are paid before other equity holders in a liquidation preference scenario. The preference makes it more likely that, in the event the total proceeds are aren’t significantly greater than the investor’s original investment, the investor holding preferred with a liquidation preference will be able to at least recoup their original investment -- before any other other shareholders receive a distribution.
Practically, this means that a VC investor who owns 50% of a company who originally invested $10 million dollars would first be paid $10 million if a company is sold. Then they would receive half of the remaining proceeds. For example, in the event that the company is sold for $100 million, the investor would receive $10 million first, and then half of what remains for a total of $55 million. The remaining shareholders would split the remaining $45 million according to their respective ownership percentages.
Multiple Liquidation Preferences
The impact of a liquidation preference can be much greater if an investor is granted multiple liquidation preferences. A multiple liquidation preference not only protects the original investment, but also a certain level of ROI.
If the liquidation preference in the previously discussed scenario was 2x instead of 1x, the investor would be entitled to be paid $20 million before any proceeds of the sale would be distributed other equityholders. This means that the investor would first get $20 million and then half of the remaining $80 million (for a total of $60 million). Other shareholders would be left with only $40 million.
Liquidation Preference Cap
Some preferred stock has a liquidation preference cap. In these clauses, holders of preferred stock would have rights to a certain multiplier of their original investment, such as 2x or 3x. Once this is distributed, investors do not receive any other distributions until holders of common stock have received distributions equivalent to the same amount per share as preferred stock.
How do liquidation preferences work with convertible notes?
Often venture capital raised using convertible notes requires multiple liquidation preferences. This can mean that the investor is distributed a much larger share than originally bought in at—even if it is not defined until a later VC round.