In order to protect their investment, investors wish to include liquidation preference in their investment agreements.
However, it is important for a startup founder to understand what this combination of words really means, in order to avoid a situation where the founder ends up with nothing on the bank account and just the experience of having been involved in a startup.
Liquidation preference as a form of protecting the investor
Liquidation preference refers to an investor`s right to recoup the money invested in the startup in preference to other shareholders, mainly founders and employee shareholders. In some cases, however, some investors are also preferred to other investors and several tiers of preference are created.
Essentially, liquidation preference determines the order of payments in case of a sale, liquidation or transfer of all the assets of a company. The sale, liquidation or transfer of all assets of the company is referred to in the agreements usually as a liquidity event.
Liquidation preference is a form of protection for the investor. In the absence of a liquidation preference, the proceeds of a liquidity event will be divided pro rata – proportionally to the shareholdings in the company. Normally, the investor’s shareholding in the company is rather modest, so in case of a proportional distribution, the investor may end up receiving less than the amount initially invested in the company, resulting in financial loss. Liquidation preference helps to avoid ocurring financial loss to the investor.
Liquidation preference – easy math?
Liquidation preference is stipulated in the shareholders’ agreement and in the articles of association.
Liquidation preference is primarily determined through a multiplier, which helps calculate the amount to be repaid to the investor in preference to other shareholders.
The most common and founder-friendly multiplier is 1x – in such a case, the investor is repaid the amount invested; proceeds in excess of the investment amount are distributed according to the agreement. However, it is not always possible to reach such a founder-friendly agreement, and multipliers greater than one are not uncommon.
In case of liquidation preference, it is possible for the investor to reap all the rewards, and founders are able to enjoy the process without accruing monetary gains. Let’s look at the following example:
An investor invested 5 million euros in a company and received 10% of the shares. The other 90% belonged to the founders and the proceeds of the liquidation event were 20 million euros.
In the absence of liquidation preference, the investor will receive 10% of the proceeds – that is 2 million euros – and the founders will receive 18 million euros. As one can imagine, the investor would not be very happy in this scenario.
If the liquidation preference had been set at 1x, the investor would have received 5 million euros and the founders 15 million euros. In such a scenario, the investor would be satisfied, and the founders would be content as well.
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However, if the liquidation preference was set at 4x, the investor would receive all 20 million euros, and the founders would be left empty-handed. The investor would have made a nice profit on their investment, and the founders would only have their contract-negotiation skills – or lack thereof – to blame.
Thus, in the end, it is important for both, the founder and the investor, to understand how liquidation preference works, as well as its possible outcomes.
For more information on this topic contact Hedman Partners.