As many entrepreneurs discover when they first begin to seek venture capital funding, VC term sheets can be very complex. Naturally, each term in a proposed deal is subject to negotiation, but it is not always clear which terms have the greatest impact on the company’s shareholders. I therefore thought I’d highlight one extremely important but often misunderstood deal term: liquidation preference.
Although liquidation preference is nearly as important as share price in determining the value of equity held by a company’s founders, management, and VCs, it is often overlooked by entrepreneurs during negotiation because it is unfamiliar to those who have limited experience with venture capital.
What is liquidation preference?
So what is liquidation preference, anyway? Liquidation preference determines the order in which the various shareholders of a company get paid upon the liquidation of the company. When venture firms invest in a company, they generally purchase preferred stock, which means they get to redeem their shares before common stockholders like founders and company management.
The exact amount VCs get to collect as part of this preferred payout is determined by the preference multiple, which is a multiple of the original purchase price. For example, if a VC firm purchases preferred stock with a 2X liquidation preference, then they have the right to get paid double their original investment before the common stockholders get paid anything. It is not difficult to imagine that this preference might be extremely important under the right circumstances. For instance, if a VC has invested $10M with a 2X liquidation preference, and the company sells for anything less than $20M, then the common stock held by founders and management becomes worthless – the VC collects the entire exit proceeds.
Another important aspect of liquidation preference is participation. Many term sheets grant VCs the right to participate with common shareholders pro rata (i.e. proportional to the percent of the company they own) even after they have been paid their preference multiple.
To illustrate what this means, let’s continue the example above. Suppose a VC has invested $10M in a company, with a 2X liquidation preference. Let’s imagine that the VC owns 80% of the company’s shares, the remaining 20% are retained by common stockholders at the company, and the company sells for $25M.
Without participation, the VC gets paid $20M (its 2X liquidation preference), and the remaining $5M is paid out to the common stockholders. In that case, the common receives 20% of the exit proceeds, as might be expected from their percent ownership. If the VC’s preferred stock has participation rights, however, then the leftover $5M is split 80/20 ($4M / $1M) between the VC and the common. So even though the common stockholders own 20% of the company’s shares, they will actually receive only $1M of the $25M sale!
To limit the benefit received by VCs from participation, some term sheets contain a “cap”, a multiple of the original investment at which VCs no longer get to participate until they let the common “catch up” to their ownership percentage. Such caps benefit the common by allowing them to be paid their full ownership percentage, but this requires the company to sell for an amount higher than the cap in order to be effective.
- Liquidation preference has a potentially huge impact on the payout to common stockholders, and should not be overlooked during negotiation.
- Term sheets with higher preference multiples and participation rights favor VCs.
- Those with lower multiples and no participation (or capped participation) are more favorable to the company.