You’ve heard this story before. A startup raises more than $100 million from venture investors over multiple funding rounds. The billion-dollar valuation is attained – the mythical unicorn status. You see pictures of the founders with big confident smiles – as if victory is assured. The obligatory TechCrunch and Business Insider stories follow.
Then the startup stumbles. Growth slows. A bridge round is required. Details are lacking, but the founders make it known that they maintained the lofty valuation of their last round of funding. Given the startup’s struggles, that’s surprising, but we don’t yet know what they may have given up.
A year later, the startup sold for nine figures. It was not the expected billion-dollar outcome, but it nonetheless seems like a great result.
After the headlines fade, we learn that the founders and employees received no cash from the sale. Instead, the investors walked away with all of the proceeds.
Welcome to the world of liquidation preferences.
The press, and many entrepreneurs, are obsessed with valuation. That’s a trap, and your potential investors know this. In the end, when a company has a liquidation event, what matters most is how the cash from that event is distributed. If you think this is based on the ownership percentage of the stockholders on your cap table, you don’t understand liquidation preferences.
Liquidation events
Let’s start with defining a liquidation event. Here is a fairly standard definition of a liquidation event from an investment term sheet:
A sale of all or substantially all of the assets of the Company and a merger, reorganization, or other transaction in which 50% of the outstanding voting power of the Company is transferred, will be treated as a liquidation event.
There are many ways that 50% of the outstanding voting power of a company can be transferred. These transactions don’t always include cash. But for our discussion, we’ll focus on scenarios where a liquidation event is triggered by a cash purchase of the outstanding stock on your cap table.
The liquidation preference
When discussing the transfer of cash to stockholders in a liquidation event, the concept of the distribution waterfall is essential. If you have preferred investors on your cap table, you should know that cash doesn’t simply flow out based on ownership percentages.
Your venture investors received preferred stock for a reason, and one of the most important aspects of preferred stock is the liquidation preference.
A liquidation preference has three essential components. First, there is the right to receive a multiple of the original investment by the preferred investor before earlier investors and the common stockholders.
Second is the concept of participation. Participation rights allow the preferred investor to receive additional proceeds from the liquidation event after their liquidation preference. Participation rights can be capped or uncapped, and that distinction also has implications for how much cash is left for the founder and their team.
Finally, preferred stock has a conversion feature, which allows the preferred investor to convert their shares to common stock if that produces a better outcome.
It’s easier to see how this comes together with some simple examples. You will notice that I can show you how this works without ever talking about valuation.
Common facts for our examples
We will use a simple fact pattern for our four examples below.
Total amount raised: $100 million
Preferred Stockholder Ownership: 75%
Common Stockholder Ownership: 25%
Example 1
In this case, the preferred stock has a 1x liquidation preference, which means that the investors are entitled to 1x their investment before any other distributions to stockholders. Since their investment was $100 million, the proceeds of $25 million are distributed to the preferred investors. There is nothing left to allocate to the common stock.
As you can see, liquidation preferences protect the preferred investors in downside scenarios.
Let’s look at a few more examples, and you’ll see what I mean.
Example 2
The 2x liquidation preference in this example means that investors get 2x their preferred investment of $100 million before anyone other distributions. The company sale netted $200 million, but the founders and employees will get nothing.
Now, let’s introduce the concept of participation rights.
Example 3
Most preferred shares are ‘participating preferred.’ This means that once the preferred investors have received the total amount of the preferred cash distribution, as determined by their liquidation preference, they continue to receive a pro-rata share of the remaining cash alongside the common stockholders.
Participation rights are generally capped, so we’ve included a 2x participation cap in this example. In theory, this suggests that the preferred shareholders ultimately can’t receive more than 2x their original investment. However, we’ll see in a later example that there is a way around this limitation.
The waterfall starts by distributing the liquidation preference to the preferred investors, which accounts for the first $100 million.
But because these preferred shares have participation rights, the remaining $100 million is then allocated pro rata based on the ownership percentages on your cap table. As a result, your preferred stockholders take an additional $75 million of the proceeds, giving them a total of $175 million, or 88%, of the distributed cash, even though they only own 75% of the company.
You’ll also note that the preferred investors receive less than 2x their original investment, so the cap doesn’t come into play in this example. Let’s look at one more example, and we’ll see what happens when the preferred investors are capped by that participation multiple.
Example 4
As in the prior example, the waterfall starts by distributing the first $100 million to the preferred stockholders, reflecting their 1x liquidation preference.
Because these preferred shares have participation rights, the preferred stockholders then participate in the distribution of the remaining cash, pro rata, alongside the common stockholders.
But the participation right comes with a 2x cap, which means that the preferred investors can’t receive more than 2x their original investment, or in this case, $200 million. The remaining $300 million is distributed to the common stockholders. The common stockholders end up with 60% of the proceeds, even though they only own 25% of the company. An excellent result!
NOT SO FAST!
Preferred stock has a conversion feature, which allows the preferred stockholder to convert their shares to common stock. This is a catch-all protection for preferred stockholders and is particularly useful when the economic outcome is better for common stockholders.
This scenario comes into play when the startup has an extraordinary outcome and the preferred stock has a participation cap. How do you get around the cap? Convert the preferred stock to common stock, and voila, the cap is gone, and the preferred stockholders can participate in the waterfall pro rata from the first dollar.
In the above example, the preferred stockholders would simply convert to common stock and therefore be entitled to 75% of the proceeds rather than the 40% allocated to their preferred stock.
This results in the preferred stockholders receiving $375 million rather than being capped at $200 million, receiving the full 75% of the proceeds that reflects their ownership position.
As I mentioned earlier, the preferences associated with preferred stock are designed to protect the preferred investors in downside scenarios. If a company has a great exit, you will generally see the preferred investors convert their stock to common shares and participate in the liquidation event pro rata to make the most of their investment. The preferred investor can choose the option that produces the best outcome for their fund.
Preference stacks and waterfalls
I’ve tried to make these examples as simple as possible to highlight the basic concepts. In practice, this can all get very complicated, particularly as you raise multiple rounds of financing.
The liquidation preference and participation rights are specific to each series of preferred stock. In other words, it’s possible, and quite common, for various series of preferred stock to have different liquidation preferences and participation rights. You might hear the phrase “preference stack,” which refers to the layers of liquidation preferences that are a part of your cap table after successive rounds of funding.
The calculation of the cash distribution ‘waterfall’ becomes more complex as you have a growing preference stack, requiring you to move from layer to layer to distribute a shrinking pile of cash.
Later-stage investors will use preferences to give them a distribution advantage over earlier preferred stockholders, pushing common stockholders further down the preference stack.
This is a crucial reason you must create a competitive dynamic between competing investors in every fundraise so that competitive pressures to get into your deal keep help keep these terms reasonable.
A word of caution
If your startup gets in trouble, with the end of your runway rapidly approaching, you lose all of your leverage. If you find investors willing to step in and support the company, they can use this situation to their advantage. You can expect the demand for higher liquidation preferences and dilutive provisions such as ratchets, which dramatically reduce the risk to these investors.
These provisions only raise the bar on the valuation required in an exit for the founders and employees holding common stock to see any meaningful value in their equity.
That’s how the story of the unicorn startup that hit some bumps in the road ends with founders and employees holding a bag full of glorious press clippings instead of money.
What about valuation?
Did you notice that we didn’t talk about valuation? That’s because valuation is about ownership percentages. As you’ve seen, ownership percentages certainly do matter if you have a great outcome, as the cash gets distributed pro rata. But structure on your cap table, in the form of liquidations preferences and other preferred investor-friendly provisions, can significantly impact the amount of cash that founders and employees will see when you sell or IPO your company.
This is crucial. Don’t trade valuation for structure. You’re almost always trading your short-term goal of maintaining the optics of a high valuation while trading away significant economics down the road. Do the math. Understand your cap table’s waterfall. And remember. Valuation gets the headlines. Liquidation preferences get the cash.