This post is the fourth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior three posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, and discussed dividends on preferred stock. This post will focus on liquidation preferences.
The liquidation preference is essentially what makes preferred stock “preferred.” It is the most important economic provision in a venture capital financing transaction other than the valuation. The liquidation preference provisions govern how the proceeds will be distributed to shareholders when and if the company is actually liquidated or is sold in an M&A transaction (called a “deemed liquidation”). Shareholders with a liquidation preference receive the proceeds of liquidation or deemed liquidation before the common shareholders and may, depending on the exact terms of the liquidation preference, receive a percentage of the proceeds that is greater than their percentage ownership of the company (resulting in other shareholders receiving a percentage of the proceeds that is less than their percentage ownership). The liquidation preference does not come into play if the company goes public, as the preferred stock issued to investors converts to common stock, and the liquidation preference goes away.
The amount of a liquidation preference can vary but is usually linked to the purchase price of the stock itself. For instance, if a VC buys the preferred stock for $1 per share, then the liquidation preference will be equal to $1 per share. This is known as a 1x liquidation preference. However, liquidation preferences can be equal to multiples of the purchase price, resulting in 2x, 3x, or higher liquidation preferences. They can also be combined with preferred dividends. For example, a VC term sheet could provide for a 2x liquidation preference plus an 8% cumulative non-compounding preferred return. After three years, the liquidation preference would be 224% of the original purchase price (2x the purchase price plus three 8% returns). High liquidation preferences combined with preferred dividends can easily wipe away any economic reward for the common shareholders, so it’s important for a startup not to give away too much in this area.
There are two basic types of liquidation preference provisions: participating preferred and non-participating preferred. Holders of participating preferred shares receive the liquidation preference applicable to those shares and also receive a portion of the proceeds after all liquidation preferences have been paid out as if they had converted their preferred stock to common stock. Holders of non-participating preferred shares receive only the liquidation preference and cannot “participate” as common shareholders. However, since preferred shareholders can usually convert their shares to common shares at any time, in practice, this means that holders of non-participating preferred shares receive the greater of their liquidation preference or what they would have received if they were common shareholders. Participating preferred shareholders receive more than their percentage ownership of the company on an as-converted-to-common-stock basis (and consequently cause common shareholders to receive less), whereas, with non-participating preferred shares, the liquidation preference will become meaningless if the company sells for a high enough amount.
Founders prefer that investors receive non-participating preferred shares, while investors prefer to receive participating preferred shares. This point can be particularly contentious in a term sheet negotiation. One potential compromise is to issue participating preferred shares subject to a cap on participation. A cap on participation limits the amount received by the preferred shareholders to a fixed amount. The cap is often set as a multiple of the original investment amount, such as 2x or 3x. Once the preferred shareholders have received the cap amount, they stop participating in distributions with the common shareholders. Consequently, if the exit event amount is high enough, the holders of preferred shares would be better off converting them to common shares, similar to the way they would be if they held non-participating preferred stock with a liquidation multiple.
Let’s take a look at an example. Let’s say that a venture capital fund takes a 20% interest in Company X for $2.0 million (an $8.0 million pre-money and $10.0 million post-money valuation). The price is $1 per share with a 1x liquidation presence and no preferred dividends. Assuming there are 8 million common shares outstanding, the VC fund would receive 2 million preferred shares.
Let’s say Company X is sold a few years later for net proceeds of $30 million. The results would be as follows upon liquidation:
| Class | If Preferred Shares are Participating Preferred | If Preferred Shares are Non-participating Preferred |
|---|---|---|
| Preferred Shareholders | $7.6 million (25.33%) | $6 million (20%) |
| Common Shareholders | $22.4 million (74.67%) | $24 million (80%) |
In an alternative scenario, if Company X sold for a disappointing $3 million, the results would be as follows:
| Class | If Preferred Shares are Participating Preferred | If Preferred Shares are Non-participating Preferred |
|---|---|---|
| Preferred Shareholders | $2.2 million (73.33%) | $2 million (66.67%) |
| Common Shareholders | $0.8 million (26.67%) | $1 million (33.33%) |
As you can see, how a liquidation preference is structured can make a big difference when the proceeds of a company sale are divided up. Therefore, startup founders should pay particular attention to this provision when negotiating term sheets.
In the next post, we’ll discuss the conversion features of preferred stock.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
