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VC Term Sheets: Liquidation Preferences and Participation

by Samantha Ku

VC Term Sheets: Liquidation Preferences and Participation

In our previous posts in this series on venture capital (“VC”) term sheets, we looked at the basic structure of an investment and at anti-dilution provisions. Now let’s turn to two concepts that can have a big impact on the way that money is allocated between the investors and everyone else when a company is sold – liquidation preference and participation.

Liquidation Preference

A VC investor is taking a big risk in investing in an early-stage company. To help minimize that risk, the investor typically expects a liquidation preference. A liquidation preference helps insure that the investor gets paid before others if there is a liquidity event (such as when a company is sold, declares bankruptcy or goes public). This is especially important when the company is being liquidated for less than the amount invested in it, since there will not be enough cash to go around, and the VC investor will want to be as close as possible to the front of the line.

The industry standard is that the VC investor gets dibs on the amount of money it originally invested (a “1x” liquidation preference). However, it’s possible that a VC investor could demand a 2x or 3x liquidation preference, or even more. But VC investors have a good reason to not insist on excessively high liquidation preferences. The greater the liquidation preference, the lower the potential value of equity used to attract qualified employees, especially those on the management team. Attracting the right employees and properly incentivizing them is essential to the growth of the company. If, as everyone hopes, the company does very well, selling for significantly more than it’s value at the time that the VC invested, then the value of the liquidation preference will be small in relation to what the VC is entitled to as a shareholder.

Rather than boosting the liquidation preference multiple, another route used sometimes by VC investors is asking for participating preferred.

Participating Preferred

With participating preferred, a VC investor gets an additional payout that comes after it has exercised its liquidation preference. For example, if an investor owns 20% of a company in the form of participating preferred stock, it will receive the amount it originally invested (its 1x liquidation preference) before any other shareholders are paid. Plus, the investor will receive 20% of the cash left over after everyone else who has a higher priority is paid. Essentially, participation gives the investor the right to double dip – it gets the liquidation preference plus the economic value of the preferred stock as converted to common stock.

The industry standard is that the VC investor gets dibs on the amount of money it originally invested (a “1x” liquidation preference).

Without the participation right (“non-participating preferred“), the investor has to choose: it can either get the liquidation preference amount or the value of its preferred stock as converted to common, but not both. There is no double-dipping.

A compromise position is capped participation, which allows the investor to double dip, but only up to a point. The VC investor is entitled to receive a share of the leftovers based on its stake in the company, capped at a certain multiple of the original investment amount, including the liquidation preference. So, for example, if participation is capped at 3x, the VC investor is guaranteed 1x the investment via the liquidation preference, and may receive up to 2x the investment out of the leftovers. Alternatively, the VC investor can opt to convert to common and receive its share of proceeds alongside common shareholders.

When multiple rounds of financing come into play, liquidation preferences may be stacked, or prioritized by series (i.e., Series B gets its liquidation preference before Series A does). Alternatively, the different series could get the same priority, or pari passu, and each will receive the same percentage of its liquidation preference returned until the money runs out or until everyone’s liquidation preferences have been met.

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While liquidation preferences and participating preferred can be complicated, they are important concepts to understand when evaluating a term sheet. The advice of an experienced attorney is essential in helping you navigate them.

In our next post in this series, we’ll look at pro rata rights, employee option pools and vesting.