Updated Feb 11, 2024
Startup fundraising is big business, and in most cases, involves venture capital (VC) firms, which are companies that are in business to invest in (and hopefully reap the benefits from) startups. However, there is no guarantee that an investment will launch the next Google, Facebook or Tesla; these investors, who are putting big bucks on the line, are astutely looking for some sort of safety net in case things don’t go as expected. One of the common practices used for helping to protect the funding in these instances is liquidation preference.
What Is Liquidation Preference?
Liquidation preference is a legal term, typically found as a clause in venture capital contracts. It dictates the payout order in the event of a corporate liquidation, which is when a business is defunct and/or insolvent and it’s time to distribute its assets. Liquidation preferences state clearly who gets paid first (and how much) in the event of a sale or liquidation of a company. There is a standard pecking order of who is toward the front of the line if and when the company is sold or liquidated.
Although it’s often overlooked in the big picture, it can greatly influence an early-stage investor’s overall returns. It’s important for businesses navigating such situations to seek professional guidance from experts in insolvency services to ensure compliance with legal requirements and optimize the outcomes for all stakeholders involved.
When and How Liquidation Preference Is Used
In short, liquidation preferences are a type of protection that investors use. In the event of a company that fails to meet expectations or sells (or liquidates) at a lower value than what was expected, there is a guaranteed payment to the investor, no matter if the company is sold or if it is liquidated.
The use of liquidation preference disposition is commonly used in venture capital firms when they invest in a startup. It is often used as a condition of commitment by the investor, so in the event of a sale or liquidation of the startup, the investor receives liquidation proceeds before other stockholders, giving a type of protection from losing money in the deal. But the scope of liquidation preference varies between circumstances, so in certain situations, it is more favorable to investors than it is in others.
However, in some instances, liquidation preference can refer to the creditors of the startup (including the bondholders) in the event of bankruptcy. In this scenario, the order of payment is senior creditors, junior creditors and then the stockholders themselves.
Similarly, the creditors that hold liens on specific items (such as a bank holding the mortgage on the real estate of the startup) often have liquidation preference over other creditors, at least as far as the proceeds from the sale of the building and other real estate is concerned.
However, liquidation preference becomes null and void in the event that the company exits via an initial public offering (IPO). In that instance, all the preferred shares are automatically converted into publicly-traded common stock.
5 Types of Liquidation Preferences
As is the case with virtually every other type of business and financial deal, there are multiple flavors of liquidation preferences, and obviously, they’re not all the same. The type of liquidation preference can have a different impact on the investor’s potential returns. The types of liquidation preferences include the following:
1. Liquidation Preference Multiple
A liquidation preference multiple determines the amount that will be paid back to an investor before the company’s founders and employees receive anything. It is typically used as part of the incentive when funding Series A or Series B rounds of investment.
For example, a 1X liquidation preference indicates the investor would receive 1X the amount invested, which is the full amount, while a 2X liquidation preference multiple would be a return of two times the original amount invested. Holders of preferred stock (as opposed to common stock) should expect at least a 1X liquidation preference when initially investing in startups.
2. Participating Liquidation Preference
Participating liquidation preference (commonly referred to as “double-dip preferred” in some circles) is highly favorable to the investor, as the investor’s liquidation preference will be paid, along with any additional proceeds, in proportion to their equity ownership.
3. Non-Participating Liquidation Preference
This is the most commonly used type and allows the investor to either receive the liquidation preference or share in the proceeds in proportion to equity ownership after converting the preferred shares into common stock.
4. Capped Liquidation Preference
Capped, or “partially participating preferred,” is when the investor’s liquidation preference is repaid, along with any additional proceeds, in proportion to the investment. But, as the name indicates, there is a “cap” placed on the maximum amount of return.
5. Seniority Liquidation Preference
Standard seniority is a structure that most startups employ. In short, liquidation preferences are honored in reverse order, starting with the most recent round. For example, Series B investors would receive their liquidation preferences before Series A, and so forth.
Pari passu seniority basically gives the investors a level playing field, at least as far as liquidation preferences go — all investors would receive part of the liquidation proceeds, with the payouts being proportional to the amount initially invested.
Tiered seniority is a hybrid model of some sort; there, investors are grouped within their funding rounds, and within each funding tier, the payout follows the pari passu model.
How To Determine Liquidation Preference
In general terms, liquidation preference allows the preferred shareholder to receive something before the common shareholder, in case the company goes into liquidation. In fact, it is entirely possible that common shareholders will receive nothing if the company doesn’t have enough assets to settle the preference amount.
There are all sorts of formulas that will determine what the preferred shareholders will receive in the event of a liquidation, but, of course, each situation is different with valuations, the number of investors (and how much investment of each) and final share price.
The CapLinked Solution
A Virtual Data Room (VDR) is a crucial tool used in virtually every type of business dealing, including VC activity and dealing with the liquidation of a company. A VDR provides a secure, online location that enables all parties involved in the transaction to review financials and other confidential documents in a secure, centrally located environment.
The features of a VDR include secure access, multiple layers of security, including enterprise-level encryption, along with customizable digital rights management that will grant only certain parties access to certain documents. An industry leader like CapLinked provides VDRs and legal document management software that features a user-friendly interface that is compatible with virtually every OS, and, because of that, it gives users the ability to work on the transaction from anywhere in the world, and using any type of computer, tablet or smartphone.
To see how CapLinked can provide a vital tool for any type of business liquidation transaction, start a free trial today.
Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.
Sources:
- Carta. What to know about equity liquidation rights and preferences. https://carta.com/blog/equity-rights-and-liquidation-preferences/
- Medium. The Ultimate Guide to Liquidation Preferences. https://medium.com/@CharlesYu/the-ultimate-guide-to-liquidation-preferences-478dda9f9332
