Liquidation Preferences

Liquidation Preference
 
One of the most important clauses that you will find in a term sheet is "Liquidation Preference" which is important for founders to be on the lookout for.
 
What's the "Liquidation Preference"?
 
It is the priority that investors have in receiving proceeds from the liquidation of a company.
 
In layman's terms, it means that the investors with a liquidation preference have the first right to get their money back before any proceeds can be distributed to other shareholders during liquidation events.
 
Example: 

An investor with a liquidation preference of 1x would get their initial investment back first before any proceeds are distributed to other shareholders.

If the investor has a liquidation preference of 2x, it means they would get twice their initial investment before any proceeds are distributed to other shareholders.
 
As a rule of thumb, founder should be very wary of liquidation preference above 1x in term sheets.
 

Participating and Non-Participating

But there are also two other terms involved in liquidation preferences - Participating and Non-Participating

Let's explain these.
 
1. Non-Participation Liquidation Preference:
 
Upon liquidation, non-participating investors have the choice of receiving their funds in either of two ways: either based on a 1x preference or according to their stake in the company, whichever is larger. Investors typically compare the potential returns from each option and select the one that would deliver the most benefit to them.
 
Example,
 
Consider Plumule Advisory has invested $4M in FoundervsFinance

Pre-money valuation = $8M,

Post money valuation = $12M.
With liquidation preference of 1x Non-Participation, stake in company = $4M/$12M = 33%
 
Upon liquidation, this same FoundervsFinance is valued at say $10M, then investor could benefit by either of.
 
 i) 1x liquidation means investors get 1x of the investment amount i.e. $4M 

OR

ii) Based on the percentage of stake - 33% * $10M (Valuation) - $3.3M.
 
It’s clear that option (i) 1x liquidation preference gives more return hence Plumule Advisory will choose the 1x option and get a return of $4M. And the rest amount of $6M ($10M - $4M) will be distributed to other shareholders.
 

2. Participation Liquidation Preference
 
During liquidation, investors with a participation liquidation preference are entitled to receive their funds through both methods i.e. a 1x preference and a percentage of their stake in the startup.


Let’s take the same example as above.

If Plumule Advisory took the 1x participation liquidation preference, then the calculation would be the same - but investors will get a return from both ways i.e. on 1x liquidation preference = $4M and and on percentage stake = $3.3M.
 
So total return for the investor = $4M + $3.3M = $7.3M.
 
The rest amount of $2.7M ($10M - $7M) will be distributed to other stakeholders.
 
Please feel free to drop your questions in the comments section.

Don’t forget to follow me on LinkedIn @GabrielOlogunwa for daily breakdowns of fundraising fundamentals.