Liquidation Preferences (IIa) - Ideal liquidity events
- Regardless of the liquidation preference chosen, by default, preferred shareholders receive their payouts before the company's founders and ESOP holders (who are grouped as common or ordinary shareholders)
- Non-participating liquidity and Participation cap liquidation preferences offer an alternative payout method for preferred investors, by converting them into common shareholders and paying them out at the same time as the founders and ESOP holders
- When there are different payout methods required to grant all investors the best possible deal, investors following their liquidation preference get paid out first, before being removed from the payout table, and the remaining shareholders paid by their percentage shareholdings
DISCLAIMER: The methods presented in this article are not hard-and-fast rules for payout calculations. These are suggestions based on the Svested team’s decades of experience assisting hundreds of companies with their CapTable calculations. In addition, the scenarios presented here are solely for the purpose of illustrating our payout calculation methods, and may not exactly reflect the scenarios companies deal with in real-life liquidity events.
In our previous CapTable series article, we did a qualitative discussion on what liquidation preferences are – including their components, and which type is ideal for founders and investors. In today’s article – the 8th in our CapTable series – we will provide you with numerical payout simulations in cases of ideal liquidity events, where the deal received by the company is amply above the total funds contributed by their investors.
Much like CapTable updating, in an ideal situation, payout simulations should be done using dedicated CapTable management software, in order to reduce the incidence of mistakes, as well as to improve efficiency. This is a feature which Svested is looking to build into our platform, as there is currently no good solution in the market.
We will base our analysis on the following company, Company X, whose CapTable is shown below. Company X has:
- 2 founders, who invested $500 and $400, with a price per share of $0.001
- 3 Seed investors (C, D and E), each receiving a price per share of $2.50
- 3 Series A investors (F, G and H), each receiving a price per share of $4.50
- The total investment received by the company is $7,875,900
The company is now about to undergo an trade sale, and is receiving a sum of $25,000,000 from the deal – an ideal scenario.
Participating liquidation preference
The first scenario we will run is a 1.5⨉ participating liquidation preference, which we assume is applied to all investors and noteholders. With participating liquidation preferences, investors are first granted a share of the company’s profit according to their liquidation payout formula, followed by a double-dip into the remaining profits, according to their percentage shareholdings. For this article, we will assume the liquidation payout formula to be: Number of shares in each class ⨉ Price per share for each class (as received by the priced round investors).
The final payout for Company X, in this situation, will be as follows:
Starting from the initial payout column on the left, the formula used to arrive at these values is: 1.5 ⨉ number of shares per class ⨉ price per share per class. The multiplication of 1.5 reflects the liquidation multiple in “1.5⨉ participating”. It is clear that the higher the multiple, the less founder-friendly the liquidation preference will be, as investors are paid out more first. As for the price per share per class, they are, respectively, $2.50 (Seed) and $4.50 (Series A). The total initial payout is $11,812,500
Note that in the initial payout, the founders and ESOP pool are not considered. This will be the case by default, because investors must first minimally receive their initial payout as stipulated by their liquidation preference, before the remaining pool is opened to the founders and ESOP holders.
Once the initial payout is settled for the investors, then the “double-dip” begins for investors, and the founders and ESOP holders receive a cut of the pie. The “double-dip” payout amounts are found simply by taking each stakeholder’s percentage shareholdings ⨉ remaining fund pool (the remaining fund pool is, in this case, $13,187,500).
The total payout and payout multiple for each stakeholder are very simple to calculate. The total payout is the sum of the initial payout and double-dip payout, while the investment multiple is found by taking the total payout and dividing it by the original investment for each stakeholder.
In this case, each tranche of investors receive the same payout multiple (3.15 for Series Seed investors and 2.42 for Series A investors). However, IF the company happens to have noteholders, it is likely that they will enjoy a higher payout multiple than the other priced round investors in their respective rounds. This reflects the additional benefits enjoyed by noteholders for having made their investment into the company earlier.
Non-participating liquidation preference
The second scenario we will show is a 1⨉ non-participating liquidation preference, again applied to all preferred investors, with the same liquidation payout formula of Number of shares in each class ⨉ Price per share for each class. For this liquidation preference, preferred investors will get the higher of either (a) to follow their liquidation preference, or (b) to receive payouts based on their percentage shareholdings.
If the latter is applied, it effectively means that the preferred investors are giving up their preference share rights to become common shareholders, on par with the founders, and receive their payout at the same time as the founders. However, the fact that investors can make this choice, represents greater flexibility.
The payout table for Company X, if all its preferred shareholders’ liquidation preferences are followed, will be as such:
The initial payout is simpler this time, due to how the liquidation multiple is 1⨉ – the liquidation payout formula can simply be followed, without additional multiplication. Once the preferred shareholders receive their initial payout, unlike the participating case shown above, there is no “double-dip” they are entitled to – the remaining funds are distributed to the founders and ESOP holders.
Consequently, with the exception of converted noteholders, all other preferred investors receive a payout multiple of 1⨉. Note that similar to the 1.5⨉ participating case above, only the preferred investors receive the first round of payouts – the founders and ESOP pool are paid out second.
However, our job is not done yet. Remember that non-participating liquidation preferences allow investors to receive the higher of (a) or (b). As such, they have an alternative: receiving their payouts according to their percentage shareholdings.
Going by percentage shareholdings – directly taking each stakeholder’s percentage shareholdings and multiplying that by the $25,000,000 received by the company – we have:
In this case, all stakeholders – including the founders and ESOP holders – are paid out at the same time. Using this method, the payout multiples are higher across the board for all preferred investors, while the founders receive a significantly smaller value. Since Company X’s preferred investors get a better deal from going by percentage shareholdings, this approach should be the one used to compute their payouts.
Participation cap liquidation preference
Last but not least, let us consider a 1⨉ participating with a 2⨉ cap liquidation preference. Investors will receive the higher of (a) their liquidation preference payout, but with the total payout limited to 2 times that of their originally invested amount, or (b) payout based on percentage shareholdings, after converting their preference shares to common shares.
Following the liquidation preference and previously discussed payout formula, the payout table will be as follows:
The initial payouts are easily calculated – similar to the 1⨉ non-participating liquidation preference, simply take the Number of shares in each class ⨉ Price per share for each class. Because the liquidation multiple is 1⨉, there is no additional multiplication of the payout at the initial stage.
For the double-dip payout, notice the numbers in red for the preferred shareholders – these numbers are calculated with reference to the maximum payout that each investor can get, which is 2 times that of their originally invested amount. For instance, Investor C, having invested $625,000 initially, is only entitled to a maximum combined payout of $1,250,000 (= 2⨉ $625,000). Therefore, Investor C’s double-dip payout is capped at $625,000 (which is equivalent to their originally invested amount). If we repeat the same logic and process for all investors, true enough, in the payout multiple column on the right, all the investors have the same, exact payout multiple of 2⨉.
As for the founders and ESOP pool, we simply take their relative percentage shareholdings (after removing all the investors’ shares), and multiply that by the remaining funds after paying out the investors. For instance, considering only the founders and ESOP pool, Founder A has a relative percentage shareholding of 47.62% (= 500,000 shares / 1,050,000 shares), while Founder B and the ESOP pool respectively have 38.10% and 14.29%. Multiplying each percentage figure by the remaining pool of funds – that is, $10,473,000 (= 25,000,000 – $7,695,000 – 6,832,000), we get the remaining payouts for these 3 entities.
But this is not the end of the story yet. Recall that for participation cap liquidation preferences, investors can choose to be paid out by percentage shareholdings as well, if it grants them a greater payout (and payout multiple). Identical to the payout table for the 1⨉ non-participating scenario above, the payouts will be as follows, if all investors convert their preference shares to common shares, and get paid out via percentage shareholdings:
An interesting case is presented here – while the Series Seed investors (C, D and E) receive a higher payout multiple than if they had exercised their liquidation preference, the Series A investors (F, G and H) instead receive a lower payout multiple, which is suboptimal for them. This is a special case, explained below, which typically will require negotiations among the founders and all investors.
In order to get the best payout possible, there may be cases where some preferred shareholders are paid out by their liquidation preferences, while others are paid via their percentage shareholdings. This is a form of compromise, and may end up being the case in scenarios similar to that shown directly above, changing a payoff method benefits 1 tranche of investors, but disadvantages another. Such scenarios typically happen when the exit valuation is less than the company’s post-money valuation of the last round
In such instances, the shareholders who are to be paid based on their liquidation preferences, will be paid first. Once this is done, they are removed from the company’s CapTable, and the relative percentage shareholdings of the remaining investors, together with the founders and ESOP pool, will be re-calculated, and the investors will receive their payout based on this new percentage shareholdings.
Following from the scenario presented above, 1 possibility may be that the Series A investors stick to their 1⨉ participating with a 2⨉ cap liquidation preference, while the Series Seed investors convert their shares to common shares, in order to receive their payout via relative percentage shareholdings.
Should this happen, the final payout table will look something like:
Using this approach, the Series A investors receive their 2⨉ payout without a hitch – a payout that is better than what they would have received, going by percentage shareholdings. For the Series Seed investors, while they do not receive as high a payout multiple of 3.13⨉, their final payout multiple of 2.82⨉ remains higher than what they would have received if they had followed their liquidation preference.
Payout calculations in reality
In reality, payouts are far more complicated. Some of the reasons for this include:
- A company’s CapTable might, in reality, be far more complicated than shown in this article, especially in terms of the number of shareholders and share classes
- There may be noteholders who, in receiving a different price per share than that of their fellow priced round investors, complicate calculations
- The liquidation payout formula may not be the same as that expressed in this article, nor might it even be explicitly stated in the shareholders’ agreement (instead leaving it up to the founders’ interpretation)
- A single shareholder may own shares from different fundraising rounds
- Liquidity events may not grant founders as good a deal as seen in this article
This article has given you a detailed insight into how payouts are calculated for investors, depending on the type of liquidation preference selected. It is crucial for founders to know whether or not their investors will be paid out first as preference shareholders, or will receive payouts at the same time as themselves, as common shareholders. At the same time, founders should take note that in the case of non-participating and participation cap liquidation preferences, they should recommend and give their investors the payout option that maximises returns.