Welcome to our series on M&A negotiations at tech startups. I’ve carefully chosen four topics after speaking with our awesome readers.

  • Part I: Your complete guide to Liquidation Preferences

  • Part II: Your Complete Guide to Single and Double Trigger Vesting

  • Part III: Your Complete guide to Negotiating Employee Earnouts

  • Part IV: Your Complete guide to Negotiating Working Capital Pegs

Why Do Liquidation Preferences Exist?

The majority of startups don’t work out. That means companies may exit for a value less than the amount of cash they raised.

Carta crunched the numbers and saw that 254 startups on the platform closed down in Q1 of 2024, more than any other quarter to date, and 58% higher than the prior year period.

Source: Carta

With only 20% to 30% of companies who raised a Seed round making it to Series A (Source: Dealroom), liquidation preferences serve as downside protection for investors if the company exits for less than what was initially expected. And it also means the investors get out before the common shareholders (employees + founders).

Liquidation Features

In exchange for downside protection, investors pay a premium for preferred shares, which may have one of the following features:

1) Multiple of Invested Capital

This is most relevant when the outcome is below the amount of capital put in. It states how many times over the investor gets their initial investment back before any of the common shareholders get a bite (assuming there’s even enough to get to that total minimum threshold).

Example:

  • Company sells for $80M, and there’s $10M invested in Preferred shares with a 2x Multiple. The Preferred represent 20% ownership (common holds the remaining 80%)

  • The preferred shareholders get a 2x return on their initial investment:

    • 2 x $10M = $20M

  • After paying the liquidation preference, the remaining proceeds are $60M ($80M - $20M). The common shareholders split this up.

    • However, let’s say it’s a true downside situation - if the company sold for only $15M, all $15M would go to the investor, and none would be left for common

    • You must apply any Multiples (and in the correct order, based on share class seniority, if it exists) before you proceed to check the Participating feature (see below)

2) Participating Preferred

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