Explore the concept of liquidation preference and its impact on startup investors.
Liquidation preference is a term used in the world of startup investing that refers to the order in which investors are paid back in the event of a liquidation event, such as an acquisition or bankruptcy. It specifies the rights and priority of different classes of investors when it comes to distributing the proceeds from the sale of a company or its assets.
In simple terms, it determines who gets paid first and how much they receive before any remaining funds are distributed to other investors or shareholders. The liquidation preference can have a significant impact on the return on investment for different classes of investors.
Non-participating liquidation preference is a specific type of liquidation preference that provides investors with a fixed return on their investment before any remaining proceeds are distributed to other shareholders.
With non-participating liquidation preference, investors have the option to either receive their predetermined multiple of the original investment amount or convert their preferred shares into ordinary shares and participate in the distribution of remaining proceeds on an as-converted basis.
With non-participating liquidation preference, once the investors receive their predetermined return, they no longer have any right to participate in the distribution of the remaining proceeds. Or they can forgo their fixed return and participate in the proceeds of the sale proportionately to the percentage of the company they own.
Non-participating liquidation preference offers certain advantages for investors. It provides them with a predictable and fixed return on their investment, which can be appealing for risk-averse investors. Additionally, it allows investors to choose between receiving their predetermined return or converting their preferred shares into common shares and potentially benefiting from any additional proceeds.
However, depending on the specific terms, it can create misalignment between investors and ordinary shareholders, as the preferred shareholders may stheir fixed return over the overall success of the company.
Non-participating liquidation preference is often contrasted with participating liquidation preference. With participating liquidation preference, investors not only receive their predetermined return but also have the right to participate in the distribution of any remaining proceeds on an as-converted basis. This means that participating preferred shareholders can potentially receive both their predetermined return and a proportional share of the remaining proceeds.
The key difference between non-participating and participating liquidation preference lies in the extent to which preferred shareholders can benefit from the sale of a company. Non-participating preferred shareholders have a fixed return and do not share in any additional proceeds, while participating preferred shareholders can potentially receive both their predetermined return and a share of the remaining proceeds.
Liquidation preference is commonly seen in venture capital and startup investments.
For example, let's say an investor invests €1m in a startup with a 1x non-participating liquidation preference and following the investment owns 15% of the company. If the startup is later acquired for €10m, the investor could choose to either (i) receive their initial investment of €1m multiplied by 1, resulting in a €1m return; or (ii) forgo its liquidation preference and instead receive its proportional share of the proceeds, resulting in a return of €1.5 million (15% of €10m). In each case, the remaining proceeds would then be distributed among other shareholders.
However, if the company is instead acquired for €5m, the investor's proportional share of the proceeds would result in a return of €750k (15% of €5m). In which case, the investor would stick with it's right to receive its initial investment of €1m.
With a 1x participating liquidation preference, the investor would receive both its initial investment of €1 million and 15% of the remaining proceeds, being a total return of €2.35m ((€1m x1) + 15% of €9m). The remaining proceeds would then be distributed among other shareholders.