Your Complete Guide to Liquidation Preferences

June's four part series on M&A negotiations at tech startups

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

This takes Multiple to the next level. It’s relevant when the outcome is above the amount of capital put in (i.e., “the pref stack”).

Participating liquidation preferences, also known as “participating preferred” or "fully participating preferred," allow investors to recoup their initial investment first, and ALSO share in the remaining proceeds like everyone else.

It’s essentially double dipping into the proceeds; first investors get a bite off the top, and then they hop back in line for more.

Example:

• Company sells for $100M, and there’s $10M invested in Preferred shares with a 1x Multiple. They represent 20% ownership (common holds the remaining 80%)

• The investors take their $10M off the top first, so the remaining proceeds are $90M ($100M - $10M)

• They also participate in the remaining proceeds as if they held common

  • Preferred shareholders get 20% of $90M = $18M

  • Common shareholders get 80% of $90M = $72M

• So if we add it all up, the Participating Preferred shareholders got a total of $28M ($10M off the top + $18M in participating) of the $100M in proceeds, representing 28%, or +8% more than their fully diluted ownership on paper

3) Capped

Capped participating preferred shares put a cap on the total amount preferred shareholders can receive, which benefits the entrepreneur and employees by limiting the investor’s upside. This is less common, but rumor has it that OpenAI has this feature.

Example:

• Company sells for $100M, and there’s $10M invested in Preferred shares with a 2x liquidation preference multiple representing 20% ownership with a 3x cap (the common hold the remaining 80%)

• The preferred shareholders get their initial investment back first, of $20M (2 x $10M)

• After paying the liquidation preference, the remaining proceeds are $80M ($100M - $20M).

  • Preferred shareholders then participate in the remaining proceeds as if they held common shares.

    • So initial math says they would get 20% of $80M = $16M.

    • However, their total payout (including the liquidation preference) is capped at 3x their original investment.

    • $20M in Multiple + $16M in participating = $36M

      • Since they already received $20M, they can receive up to an additional $10M from the remaining proceeds, for $30M total, or 3x

• The remaining $70M goes to common shareholders, preserving $6M

The Liquidation Stack

Let’s take this liquidation stuff to the next level. There are three types of seniority structures that determine which class of shares get paid out first (Source: Fidelity):

1. Standard. Later stage investors receive their liquidation preference first (e.g. D, C, B, then A). So it goes in reverse order.

2. Pari passu. All investors receive their liquidation preference at the same time. This is a fancy Latin (French? IDK) word for “equal footing”. It’s the cleanest, simplest structure.

3. Tiered. Classes are grouped together (e.g. F and E, D and C, B and A). Then, the tiers receive their liquidation preference in standard order. And within each tier, classes receive payouts in a pari passu manner. So it’s kind of a combination of both above.

There are some dependent decisions here, as you might have sniffed out, especially when investors are non-participating and deciding whether they want to convert or not.

Therefore, decisions will always start in order of investors with the highest conversion point (typically at the latest stage) to the lowest conversion point. This ensures that conversion decisions are optimal for all parties (Source: Next Big Teng).

What about the me?