Some of us end up as an early stage “Angel investor” by accident. We aren’t overtly looking to invest in new ventures. But given our success and community standing, prospects to invest in early stage business start-ups end up on our doorstep with frequency. And suddenly, one catches our eye in particular, and before we know it, we are involved.
Although we wouldn’t invest in anything that we didn’t feel had promise, the reality is that these kinds of investments have a very high risk. Thus, it’s prudent to anticipate the potential outcome when things may go wrong. And as we provide capital in exchange for preferred stock or convertible debt, it’s important to understand the liquidation preference from the outset. Jim St Jean offers insights to that end from his experience as an active Angel himself, as well as a veteran of the software venture startup trenches.
I wanted to talk a bit about the liquidation preference. I recently received a distribution from one of my investments that did not succeed. The company was struggling, was out of cash, and took an opportunity to sell out at a fairly low price. The price was much less than the total capital they had raised. I got some money back – not all of my capital, but some of it. Many other investors in the company got nothing.
The distribution of funds was dictated by a key right that that was attached to my preferred stock: the liquidation preference. This is the most common, and in many ways most important, right that comes with preferred stock. Investors insist on it. The liquidation preference is very important to protect the investors’ capital. Any entrepreneur needs to understand this term and how it works if they are meeting with investors. If you are an investor new to early stage investing, you need to be aware that it is a key feature that you need to include in your funding agreements.
The Liquidation Process
The fact is that in this weak economy, more start-ups are failing. Many of those that do not fail are being forced to do down rounds. When a start-up fails, often there is some money that becomes available depending on the liquidation process – an acquisition or asset-sale will usually generate some cash. First to get paid are the lawyers who did the deal, then any debt holders. If there is additional money available, it goes to holders of preferred stock with a liquidation preference. Then, only after they have been fully repaid the original investment amount (or another amount that is negotiated), remaining funds may be available to non-preferred shareholders.
When companies raise multiple funding rounds over time, it is not unusual to actually build up a hierarchy of preferred stock holders. Each later investor might get priority treatment over the prior investors, or what is called a senior liquidation preference. So if a company raised three rounds of money, let’s call them the A, B, and C rounds, then the company may have four separate classes of stock, common shares and three different classes of preferred shares. If senior liquidation preference rights are present, then the series C preferred stockholders take priority over B, who take priority over A, who take priority over the common shareholders. Each class is entitled to get their original investment dollars back (or another amount that is negotiated) before anyone else can get any of the remaining cash.
Let’s look at a simple example:
- Founders start a company called New Corp and put in their life savings to get it off the ground. They hold common shares.
- Investors put 1 million dollars into the company in a series A round. They get series A preferred stock with a liquidation preference over the common shareholders. Sorry, founders.
- Later, additional investors put 2 million more dollars into the company. They get series B preferred stock with a senior liquidation preference over the series A holders.
- And some time later, new investors put 5 million dollars into the company and get series C preferred stock with a senior liquidation preference over the series B and A preferred shareholders.
New Corp struggles and burns through cash. The CEO the series C investors brought in likes to fly first class and lavishly decorate his office. New Corp eventually gets rid of the CEO, but has run out of money and is unable to raise additional capital because the market and economy have soured. Nobody is buying their products anymore. They are approached by a larger competitor and presented with an opportunity to sell the company for 4 million dollars, which will ensure the remaining employees can keep their jobs, and the existing customers will be supported. The board decides to take the deal.
It is a better option than shutting the doors.
Where does the 4 million dollars in proceeds go? After the lawyers are paid and any outstanding debt holders are paid, the remainder goes to the series C preferred stock holders. The B, A, and common stockholders get nothing. The senior liquidation preference ensures that the series C stockholders will be entitled to get their full 5 million dollars back (assuming a 1x liquidation preference) before any of the other stockholders get anything. In this case, the series C stockholders will get up to 80% of their money back, but everyone else, including the founders, will lose all their money.
Alternative Liquidation Preference Approaches
Not all early stage financings involve senior liquidation preferences. Sometimes all preferred stockholders share that preference on an equal basis. It is one item to be negotiated, and in some ways will be driven by the terms of whatever the last investment round was. Once a precedent gets set, it is likely to continue into all funding rounds. Therefore terms in early financings turn out to be very important in setting the tone for later rounds.
This has covered the basics of the liquidation preference, but there are many scenarios and configurations. Sometimes investors can be entitled to take out more than they put in (for example a 2X or 3X liquidation preference). Sometimes they can be entitled to be paid dividends. “Participating preferred” terms mean not only does the investor get their money first, but is then entitled to their share of leftover funds as if they were a common shareholder too (“double dipping”). Amounts can also be capped.
The Risks for Angel Investors
The situation points out the risks to earlier investors, especially angel investors, who tend to lose control over their investments when later rounds are done. They get pushed down the stack. The founders, unfortunately, never win unless the company succeeds. That is usually what investors insist on. The founders need to be motivated.
I was lucky in my investment. I participated in the last funding round, had a senior liquidation preference, and when the company was sold off I got about half my money back. I would like to think I was really smart, but the fact is the terms were negotiated before I got involved. And, unfortunately, the company did not make it, which is never a good outcome.
In reality, the majority of companies experience some sort of exit event that is not ideal. Liquidation preferences play a very important role in these cases. It can even play a role in “good exits” in that it can direct outsize proceeds to preferred stockholders, or create funny incentives when the investors are entitled to receive identical payouts under different scenarios that treat common shareholders unequally. Founders and investors need to clearly understand these terms and work through what happens in various scenarios.
This has been a basic overview of the liquidation preference. For more information, I suggest some follow-on links, which include sample text, examples and language from actual deals.
About the author
James St. Jean leads global technology, innovation and product engineering at Meltwater. Jim is focused on building a world-class software development organization that leverages the diverse talents of the company’s engineers across six development centers worldwide. Jim comes to Meltwater from the acquisition of JitterJam in 2011, where he was previously CTO. Jim is a repeat entrepreneur who has worked in the CRM and marketing sector for the past 18 years at a variety of startups and public software companies.