RTC #31: Understanding liquidation preferences

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🤿 Understanding liquidation preferences

I guess most of you have at least heard the term “Liquidation Preference” before. It is one of the most important points covered in the term sheet and investment documentation.

But why is it so crucial to understand what it means and its practical impact?

Let's look at the FanDuel case study:

• Founded in 2007 with the vision to revolutionize the sports betting industry.

• Their seed round raised approx. USD 0.4m in the same year.

• They went on to secure nearly USD 420m in investments, progressing from their Seed Round to a Series E+.

• In 2018, FanDuel was sold for USD 465m.

Now, guess how much the founders received from this EXIT?

One of the main reasons was the liquidation preferences that the investors had in place when investing their capital.

This ensured that they were paid first in any sale scenario meaning that the investor’s money was prioritized over common shareholders, which included the founders.

Today, I will explain the concept of liquidation preferences (“Liq Prefs”) to you and go through the different types using an example case to show you the impact in an EXIT scenario.

Common versus Preferred Shares

Venture Capital investors usually receive some sort of preferred shares for their investment. This means that they secure themselves significant additional rights versus the founders. The shares of the founders are usually called common shares.

• Preferred share term sheets almost always include a liquidation preference.

• This means that the VCs get their money back before common shareholders get anything.

How does a liquidation preference work?

A liquidation preference gives investors the option, during a liquidity event, to either:

• Receive their liquidation preference as their return, or

• Convert their investment into common stock and receive their percentage ownership as their return.

It is the amount the company must pay to investors at exit, after settling debt obligations. This preference determines how the exit proceeds are distributed between preferred shareholders (the investors) and common shareholders.

The liquidation preference is often expressed as a multiple (e.g., 1.0x) of the initial investment.

Let’s have a look at the different types of Liq Prefs:

Assumptions for our EXIT calcs:

• VC invested: USD 3.0m (@USD 10.0m post)

• Shareholding VC: 30%

• Valuation at EXIT: USD 15m

Type 1: Non-participating preference - “straight preferred”

👉 The investor chooses between a return of capital, sometimes partial, (Scenario 1), and participation with the common shareholders in proportion to their ownership (Scenario 2).

👉 If the investor chooses return of capital, any remaining proceeds are divided among common shareholders

👉 In our case let’s assume a Liq Pref of 2.0x

➡️ Scenario 1 (Liq Pref): 2.0x * USD 3.0m = USD 6.0m

➡️ Scenario 2 (pro rata proceeds): 30% * USD 15.0m = USD 5.0m

In this case, the investor would receive USD 6.0m given the liquidation preference he would choose.

Type 2: Participating 1.0x liquidation preference - “participating preferred”

👉 In this structure (sometimes called “double dipping”), the investor first receives the capital (1x preference) and then the shares convert to common

👉 Post returning the capital to the investor, the gains from the sale of the company are distributed in proportion to (pro-rata) ownership, but including the preferred investor on the second distribution on an as-converted basis

➡️ First tranche: 1.0x * USD 3.0m = USD 3.0m

➡️ Second tranche: 30% * (USD 15.0m - USD 3.0m) = USD 4.0m

The investor would receive USD 7.0m in this case.

Type 3: Capped participation - “capped participating preferred”

👉 Capped participation means that the shares will participate in the liquidation proceeds on a pro-rata basis until the total proceeds reach a specified multiple of the original investment, plus any accrued dividends.

👉 In our case let’s assume (i) a Liq Pref of 1.0x and (ii) a 1.5x cap

➡️ 1.5x * USD 3.0m = USD 4.5m

The investors would receive USD 4.5m versus USD 5.0m without the cap (30% * USD 15.0m = USD 5.0m).

Are liquidation preferences more and more common to be included in term sheets?

This is what Peter from Carta says:

You thought the 2.0x Liq Pref in our example case was high?

Investors are asking for higher liquidation multipliers these days: there were 1.5x, 2x, even 3 or 4x multipliers in priced rounds in 2024. 😮

Overall, “only” 5-10% of all rounds included a Liq Pref though.

Explore today’s topic further with these useful reads

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Have a great week,
Stephan 👋

Issue #31 | 16 July 2024