Liquidation Preferences in Venture Capital

This article brings you everything that you should know.

One of the key terms on a term sheet that is frequently disregarded is ‘liquidation preferences’. This term can have a major impact on the returns of an early-stage investor. Liquidation preferences are considered to be one of the most crucial transaction terms in the venture capital community, second only to the business valuation at the time of investment. As an early-stage investor, it is critical to know what liquidation preferences and venture capital are, how they function, and what are their features, advantages, and disadvantages. This article brings you everything that you should know.

Liquidation Preferences and venture capital

Many venture capital financing agreements contain a crucial clause known as a liquidation preference. If the business is sold or goes public, it grants the venture investors the right to receive payment in full first. Let’s learn about venture capital first to gain more insights into liquidation preferences.

What is venture capital?

Venture capital is a type of private equity and financing provided by investors to startup enterprises and small businesses with the potential for long-term growth. It is often provided by investment banks, wealthy individuals, and other financial organisations.

Venture capital doesn’t necessarily need to be in the form of money. It can also come in the form of managerial or technological know-how. It is often given to startups with outstanding growth potential or to businesses that have had rapid growth and seem well-positioned to keep growing.

How does venture capital work?

The majority of funding for venture capital businesses often comes from big financial organisations like banks and superannuation funds. Large ownership stakes in a company are developed and sold to a select group of investors in a venture capital deal through independent limited partnerships that are set up by venture capital firms.

These partnerships can occasionally be made up of a group of related businesses. For a maximum of ten years, these institutions invest in a venture capital fund. Investment institutions anticipate very high returns on their investments to make up for the prolonged commitment and lack of security and liquidity.

Venture capitalists often exit their investments by selling to a trade buyer, listing the business on the stock exchange, or doing a management buyout. Even though venture capitalists might get some money back from dividends, their main return on investment comes from capital gains when they ultimately sell their firm shares, which usually happens three to seven years after the initial investment.

Hence, venture capitalists are in the business of fostering growth in the businesses they invest in. At the same time, they manage the risk involved to safeguard and grow the capital of their investors.

Benefits of venture capital

Venture capital has a lot of benefits. It can be used to finance startup businesses that lack access to stock markets or sufficient cash flow to incur debt. The agreement benefits both parties. Investors buy stock in budding startups, and businesses get the capital they require to get going. Venture capitalists frequently provide emerging businesses with mentorship services to help them get off the ground, as well as networking services to assist them find talent and consultants. Strong venture capital backing can be used to leverage additional investments.

Disadvantages of venture capital

Every coin has two sides, and hence, it is important to know about the disadvantages of venture capital. A company that takes venture capital funding may forfeit creative control over its future course. Venture Capital investors are likely to seek a sizeable portion of the company’s stock and may start putting pressure on the management of the business. Several venture capitalists may put pressure on the company for an early exit because they are simply looking for a short, high-return payment.

What are Liquidation preferences?

Liquidation preference is an investor’s entitlement to receive their money back before holders of common stock, who are often a company’s founders and employees. It is a clause in a contract that specifies the payout order in the event of a corporate liquidation. If the company needs to be liquidated, investors or favoured stockholders usually receive their money before other stockholders or debtholders. In venture capital contracts, promissory notes, hybrid debt instruments, and other structured private capital transactions, liquidation preferences are typically used to specify which investors receive payments and in what order during a liquidation event.

How do Liquidation preferences work in venture capital?

Certain liquidation preference dispositions are frequently used when venture capital organisations invest in newly founded businesses. Investors frequently stipulate as a condition of their investment that they be given precedence in the liquidation over other shareholders. Venture capitalists are guaranteed that they will receive their initial investments returned before other parties. This safeguards venture capitalists from financial loss.

There need not be a formal firm liquidation or bankruptcy in these situations. A sale of the company is sometimes considered to constitute a liquidation event in venture capital contracts. Liquidation preferences can therefore assist venture capitalists in being first in line to claim a portion of the earnings if the firm is sold for a profit. The company’s original owners, employees, and holders of common stock are often paid back after venture capitalists.

Why do Liquidation preferences happen?

Investors are protected by liquidation preferences, particularly when a company doesn’t perform up to expectations and sells or liquidates at a lower valuation. This is because, regardless of the company’s worth at exit, the liquidation preference essentially assures a specific minimum payout owed to investors.

All preferred shares instantly convert into publicly-traded common stock when a firm departs via an IPO (Initial Public Offering) is significant. While investing in startup businesses, venture capital firms run a tremendous risk. 20% of new businesses fail in their first year of operation, according to the U.S. Bureau of Labor. Liquidation preferences, thus, happen because venture capitalists want protection against this risk.

Features of Liquidation Preferences

There are four main features of liquidation preferences, which also determine the liquidation preferences structure. They are as follows:

Features of Liquidation Preferences

  • Multiples – Multiples establish the amount that must be repaid to an investor before any proceeds are distributed to ordinary shareholders. If a venture capitalist invests $2 million (M) in a company, they must be paid back $2M before any common shareholders are paid anything. This is known as a 2x liquidation preference. Regardless of the capitalist’s equity ownership, they would be guaranteed at least $2M if the company were to be sold for $2.5M. Multiples are normally 1-2x, but they can reach 10x depending on the state of the market. An entrepreneur would want to have the lowest multiple feasible so that the investor is only bound to get the minimum amount of proceeds.
  • The cap – Until the preferred shareholders get an aggregate sum equal to x-times their initial investment, shareholders with participating liquidation preferences are allowed to participate with common shareholders. The maximum amount they will receive is called ‘the cap’. Depending on the size of the exit, the investor may still choose to convert their preferred shares to common stock to participate fully and without a cap alongside the common shareholders.
  • Seniority structure – One of the features of the liquidity preferences structure is the ‘seniority structure’. It determines the order in which preferred stockholders are paid out following an exit. As businesses expand and raise new rounds of financing, more investors may join the cap table with their rights and privileges, including different liquidation preferences. Seniority structure provides the process of adding new financing partners with a sense of order. The top three seniority structures are standard, pari passu, and tiered.
  • Participating vs non-participating – In participating liquidation preference, the investor will get more “participation” in the residual proceeds in proportion to their own once their liquidation preference has been repaid. For instance, if you invest $2 million in a business that has a 1x participation liquidation preference in return for 20% ownership. You would receive a guaranteed $2 million and an additional 20% of the proceeds if the company was sold for $3 million. A total payout of $1.2M would result from paying out 20% of the remaining $1M, or an additional $200,000. Contrary to participating liquidation preferences, non-participating liquidation preferences give the investor the choice of using their liquidation preference or converting their preferred shares into common equivalent shares. Equity ownership percentage is calculated from this and they receive a portion of the proceeds based on their equity ownership of the company.

Liquidation preferences example

To have a better understanding of the process, let’s look at one liquidation preferences example.

Consider an investment of $20 million by a venture capital firm in a startup company for 30% of the common shares and $4 million in preferred shares with a 2x liquidation preference. Assume that the startup has no debts to creditors. Furthermore, its founders contributed $16 million for the remaining 70% of the ordinary shares.

Afterwards, the company was sold for $150 million. As a result, the venture capital firm would earn $8M (2x $4M) following the preferred share liquidation preference that it possesses. The startup’s common shareholders would divide the remaining $142M according to their respective percentages of ownership in the business.

How do Liquidation preferences affect the return?

Liquidation preferences highly affect the return an investor would get when a company is sold or acquired later. This matters more in case the company does not fare well and is acquired for a value less than its post-money valuation.

Let’s consider that $250K is raised for a company, and this increases its value from $1M to $1.25M. The investor would own 20% of the stocks of the company ($250K/$1.25M). Taking into account the most common liquidation preference (1x), the optimal return an investor would gain is $400K if the company is acquired at $2M (which is higher than its post-money valuation). Although, liquidation preferences affect the return the most in cases when the company underperforms.

Suppose the company is acquired for $1M (which is less than its post-money valuation). In this case, if there are no liquidation preferences (which happens when the investment is made in common stocks), then the investor would just get $200K. However, if they have invested in preferred stocks, they would get all of their investment money, i.e., $250K back. This is how liquidation preferences affect the return.

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