Liquidation Preferences (I) - What they are, and how they work

Introduction

In the previous 2 articles of our CapTable series, we discussed and demonstrated how a CapTable changes when fundraising and note conversions occur.  Apart from fundraising, however, there is another important milestone for companies – an exit, more commonly known as a liquidity event, as described in all of the documents (such as the ESOP document, shareholder agreements, shares subscription agreement and constitution).  These events can range from trade sales, mergers and acquisitions, to IPOs (with trade sale being the most preferred option).

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When a liquidity event occurs, the company is obligated to pay out its shareholders, based on liquidation preferences, whereby usually, the later the investor puts money into the company, the higher their payout priority from the company.  To determine payouts in liquidity events, founders will need to understand the liquidation preferences tied to each class of shares, before performing the relevant calculations.

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What constitutes a liquidation preference?

A few examples of liquidation preferences are as follows: “1x non-participating”; “1x participating”; “1x participating with 2x cap”.  As can be seen, there are a few elements which constitute a liquidation preference.

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1.  Liquidation multiple

The liquidation multiple specifies how much preference shareholders – specifically those of the most senior tranche, aka those first in line to be paid out by the company – must be paid out minimally before the next tranche of preference shareholders receive any payout.  Typically, the liquidation multiple is with reference to the total invested amount for each investor (or each tranche of investors).

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Let us consider Company Y, who has 3 tranches of preferred shareholders: 

• Series Seed Investors : $250,000 invested
• Series A Investors : $600,000 invested
• Series B Investors : $1,500,000 invested

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If the company receives an exit offer with a value of $2,000,000, assume also that the liquidation multiple is 1⨉ with the standard liquidation preferences stack (Series B > Series A > Series Seed), that means that its Series B investors will receive 1 ⨉ $1,500,000 = $1,500,000 first, before its Series A investors will receive the remaining $500,000.  

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In this particular case, the company’s exit valuation only grants it enough proceeds to fully payout its Series B preferred shareholders.  That is, its Series Seed and Ordinary Shareholders receive nothing.

• Series B preferred shareholders: $1,500,000 received in total (all investors will get back the amount which they have invested)
• Series A preferred shareholders: $500,000 received in total 
• Series Seed and Ordinary shareholders: Receive nothing ($0)

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For Series A investors, because there are insufficient leftover funds to fully payout each investor, they shall each receive a partial payout prorated according to the number of Series A shares they each hold, divided by the total number of Series A Shares.  That is: 

‍Payout per investor = Number of Series A shares held / Total Number of Series A shares ⨉ $500,000.  

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Should the company have received an even lower sum from its exit deal – say, $1,200,000 – if we assume that the standard liquidation preferences stack still holds, it would mean that Company Y’s Series A, Series Seed and Ordinary shareholders will receive nothing ($0), while its Series B investors only receive a partial, prorated payout similar to that discussed above: 

‍Payout for each Series B shareholder = Number of Series B shares held / Total number of Series B shares ⨉ $1,200,000.  

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Alternatively, if the company and its investors have agreed upon a pari passu liquidation seniority, in the event that there are insufficient amount to fulfil the liquidation payout, then all preferred shareholders will receive a prorated amount based on either of the formula below:

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1. Payout for each Preference Shareholders = Value of Investment made / Total Investment raised ⨉ Exit valuation (Most commonly used)
2. ‍Payout for each Preference Shareholders = Number of Preferences shares held / Total number of Preferences shares ⨉ Exit valuation.  

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Should there be a higher liquidation multiple – for instance, a 2⨉ multiple – it means that Company Y’s Series B investors will have to receive 2 ⨉ $1,500,000 = $3,000,000 minimally, before its Series A investors receive any payout at all.

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In general, companies would want to negotiate with their investors for a lower liquidation multiple, usually 1⨉, to reduce the amount of proceeds (payable from an exit) owed to investors.

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2.  “Participating” or “Non-participating”

A “non-participating” liquidation preference means that preferred shareholders have the option to (a) receive a payout in accordance with their specified liquidation preference, OR (b) receive a payout based on their percentage shareholdings, whichever is higher.  Going back to the example of Company Y above, let’s say its Series B investors had chosen a “1⨉ non-participating” liquidation preference, and own 20% of the company collectively.  

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If Company Y had an exit deal worth, say, $100 million, then its Series B investors would receive $20 million in total, according to their percentage shareholdings.  They would choose this payout option, because the corresponding $20 million payout is much higher than what would have been received if they followed their liquidation preference – that is, 1 ⨉ $1,500,000 = $1,500,000. 

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On the other hand, a “participating” liquidation preference means that preferred shareholders receive a “double dip” – that is, after receiving their minimum payout based on their liquidation preference, investors will receive a cut of the remaining funds from the liquidity event, in accordance with their percentage shareholdings.  

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Note that all preference shareholders must receive their minimum payout (according to their liquidation multiple) first, before the “double dip” is granted.  At the same time, a participating liquidation preference does not grant the option to investors to directly receive funds based on their percentage shareholdings, unlike non-participating cases.

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Referring back to Company Y, assume all 3 tranches of preferred shareholders had chosen a “1⨉ participating” liquidation preference.  The respective percentage shareholdings are: 10% (Series Seed investors); 15% (Series A investors); 20% (Series B investors).  If Company Y’s exit payout remains at $100 million, then the Series B, A and Seed investors would respectively receive $1,500,000, $600,000, and $250,000 first.  

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The remaining funds – $97,650,000 – would be subsequently re-distributed to the investors: $19,530,000 for Series B investors (= 20% ⨉ $97,650,000); $14,647,500 (= 15% ⨉ $97,650,000) for Series A investors, and $9,765,000 (= 10% ⨉ $97,650,000) for Seed investors.  The final combined payout for Company Y’s Series B, A and Seed investors would then respectively be: $21,030,000; $15,247,500; $10,015,000.

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3.  Participation cap

If investors have a participating liquidation preference with a cap, the cap – expressed as a multiple as well – specifies what is the maximum total payout that the investor can receive, with respect to their liquidation preference.  For instance, for investors with a “1x participating with 2x cap”, the maximum amount they can receive from this calculation – that is, the sum of their initial payouts and their “double dip” – will be only 2 times their originally invested amount or based on the percentage shareholdings, whichever is higher. As this case is relatively uncommon, we recommend scheduling a discussion with our team for a more detailed breakdown.

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4.  Liquidation preference amount

In general, there are 2 ways to derive the liquidation preference amount.

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(a) If investors go by an “amount invested” liquidation formula, then each investor’s total sum invested (across all fundraising rounds participated in) can directly be used. 

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Referring back to Company Y’s investors, recall that the amounts invested by its Seed, Series A, and Series B investors are respectively $250,000, $600,000 and $1,500,000, and that none of the investors participated in multiple rounds.  

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If, for instance, all investors have chosen a “1⨉ non-participating” liquidation preference, calculated by amount invested, then the investors will minimally get back $250,000, $600,000 and $1,500,000, in order of increasing seniority.  Should a “2⨉ non-participating” liquidation preference be chosen, calculated by amount invested, then the minimum payout will be $500,000, $1,200,000, and $3,000,000.

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(b) Another example of a liquidation preference formula would be: “Number of shares in each class ⨉ Price per share for that class”.  Do take note that by price per share for each class, we are referring to the price per share given to the priced round investors for the round, rather than the (discounted) price offered to noteholders.

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For instance, let’s say that Company Y’s price per share per round are as follows: 

• Series A : $1
• Price per shares of Series B : $3

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In this case, going by a 1⨉ liquidation multiple, the liquidation preference payout for Series A shareholders (including converted noteholders) will be: 1⨉ Number of Series A shares ⨉ $1.  For Series B shareholders, the payout for each investor is 1⨉ Number of Series B shares ⨉ $3.

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What is the “ideal” liquidation preference?

In an ideal world, it’s best to have no liquidation preference at all, but that is extremely rare and almost impossible to achieve.  Hence for founders, the next best option would be one that minimises their payout obligation to investors in a liquidity event.

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Thus, sensibly, a “1x non-participating” liquidation preference is considered best for founders.  Fortunately nowadays, with the increasing competition amongst VCs / Investors, liquidation preference terms are becoming friendlier. Over the past decade, we have also sighted the shift from “1x participating” to “1x non-participating.

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Conclusion

The choice of liquidation preferences can significantly alter the payout waterfall for both investors and founders alike.  In the longer term, the choice of liquidation preferences will also determine how much of an administrative hassle the founders will need to deal with when paying out its investors.  

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Also, do take note that the above calculations are based on the standard terms and also in the event of a Trade Sale or Merger. In the event of an IPO, for standardisation, all classes of shares will be converted into ordinary shares. 

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When accepting investments into their company, founders need to carefully consider what each type of liquidation preference would entail, and balance the interests of the incoming investors, existing investors, as well as their own interests.  We recommend that founders, as far as possible, try to negotiate for a 1x non-participating liquidation preference from an early stage – this way, it is less likely that later-stage investors choose a liquidation preference that significantly reduces the payout for the founders and earlier investors.

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