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February 17, 2025
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Imagine pouring your heart, soul, and countless sleepless nights into building a startup, only to discover that when it's time to exit, you might walk away with nothing. While this definitely describes an extreme scenario, Liquidation Preference is definitely one of the most important clauses in a termsheet or an SHA that can make or break a founder's financial destiny.
At its core, Liquidation Preference is an investor capital protection mechanism that determines how money is distributed during a company's liquidity event. A liquidity event could be an exit event such as acquisition, merger, etc. or in the worst-case scenario, also imply company dissolution. One can think of liquidation preference as a financial safety net for investors, ensuring they get their money back before founders see a penny.
Liquidation Preference operates on three key dimensions:
Let’s look at each of these dimensions to understand liquidation preference better.
Investors with preferred shares typically get paid first. Imagine a financial waterfall where debt sits at the top, followed by different classes of preferred shareholders, and finally common shareholders (typically founders and employees).
The multiplier determines how much investors recover before other shareholders. A standard 1x multiplier means investors get back their initial investment. However, some aggressive term sheets might include 1.5x or even 2x multipliers – a potential founder's nightmare.
Some investors don't just want their money back – they want a second bite of the apple. Participation rights allow investors to recover their initial investment AND then proportionally share in the remaining proceeds based on their shareholding.
Other than the regular participation right, there is also a concept of capped participation where investors participate in the remaining proceeds up to a certain cap after getting their initial investment back, offering a balance between investor protection and founder reward.
Let's take a practical example and break this down further:
Let’s take an example of Startup X:
As you can see from the above examples, the impact of liquidation preference can be fairly drastic in situations where the liquidation proceeds are in the ballpark of the funding amount raised. Further a multiplier factor higher than 1 along with a participating right further erodes founder value. Thus despite being a significant stakeholder in their own businesses, a founder might end up with very little value for themselves as investors might pocket a significant chunk of the liquidation proceeds as per the terms in the Liquidation Preference Clause.
Based on our analysis of several termsheets, the most widely accepted liquidation preference configuration is a 1X multiplier and no participating right.
Understand the Full Clause: While the dimensions mentioned above are the most standard ones, there could be bespoke versions of this clause. Founders should not sign-up for these clauses blindly that they don't completely comprehend. We suggest founders seek legal guidance before agreeing to these terms.
Model Different Scenarios: Founders are also encouraged to play-out the various extreme scenarios as per the liquidation preference clauses to understand the complete implications of these clauses. Founders can use spreadsheets to model the potential outcomes as indicated in the earlier example.
While Liquidation Preference might seem intimidating, it's a standard investor protection mechanism. The key is balance and fairness. Founders need to appreciate that investors are putting in significant amounts of risk by putting in money at an early stage and hence require capital protection mechanisms. On other hand, investors need to understand that overly punitive terms can demotivate founders and potentially harm long-term company performance.
Liquidation Preference isn't about antagonism between founders and investors. It's about creating a fair mechanism that protects investor capital while keeping founders motivated. Remember that the best term sheets create alignment, not division. And hence even in the case of liquidation preference, founders and investors should seek a win-win structure that incentivizes everyone to drive the company's success.
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