You should understand Liquidation Preference and Preferred Participation before joining a start-up

March 8th, 2010 · Comments

Before you join the next "exciting, top venture capital firms backed" start-up, you need to understand liquidation preference and preferred participation. As I wrote in Don’t get screwed! Startup questions you should ask before you join a startup — you could totally be screwed by a start-up. You need to know the details of the start-up’s financing structure to protect yourself. If the start-up refuses to share the details with you, you shouldn’t join the company.

Today, I would like to share with you a real world case study that explains the concepts of liquidation preference and preferred participation.

I’m not a lawyer. I’m giving you a very simple example. My intention is to get you started and give you a basic understanding. For a thorough, authoritative discussion of legal aspects of start-up financing, please read the excellent The Entrepreneur’s Guide to Business Law. In fact, I think this book is a must read for anyone who plans to start a business or join a start-up.

Liquidation preference is a legal term used by venture capitalist to protect their down side risk. They wanted to at least get their money back. Liquidation preference is very common. The most common term is 1x of venture capital investment.

Preferred participation is another device used by venture capitalists to protect their down side. It is sometime referred as "double dipping".

Let me give you an example to illustrate.

Startup X just received 3rd round of financing. Prior to the financing, Startup X is valued at $8 million dollars. Venture Capitalist put in $2 million dollars. So, right after the financing, Startup X has a post-money valuation of $10 million dollars. After the 3rd round of financing, venture capitalists owns 80% of the company, founders and employees own 20% of the company. venture capitalists have a liquidation preference of $8 million, and preferred participation of 3X liquidation preference ($24 million).

Also, in most startups, venture capitalists own preferred stocks, while founders and employees own common stocks. This means venture capitalists will get their money first before everyone else when an exit event such as acquisition takes place.

Let’s go through 3 scenarios: Bad, OK, and Home Run.

Scenario #1: Bad outcome for Start-up X. The company was crushed by competition. It’s sold for $6 million dollars.

Venture capitalists have two options:

Option #1: Venture capitalists can convert all of their stocks to common stocks. Since they own 80% of the company, they will get $6 million X 80% = $4.8 million. Founders and employees will get $6 million – $4.8 million = $1.2 million.

Option #2: Venture capitalists chooses to take advantage of liquidation preference. Since the liquidation preference is $8 million, and the company is sold for $6 million, the venture capitalists get the entire $6 million. Founders and employees will get nothing.

Obviously, venture capitalists will choose option #2 in this scenario.

Scenario #2: OK outcome for Start-up X. The company did OK, but had limited growth. The company is sold for $18 million.

Again, Venture Capitalists have two options.

Option #1: Venture Capitalists convert all of their stocks to common stocks. Since they own 80% of the company, they will get $18 million x 80% = $14.4 million. Founders and employees will get $18 million – $14.4 million = $3.6 million.

Option #2: Venture Capitalists choose to take advantage of liquidation preference and preferred participation. They will get:

$8 million due to liquidation preference
Because of preferred participation, they will be able to "double dip" for the remaining money up to the $24 million preference participation cap: they will get ($18 million – $8 million) * 80% = $8 million
$8 million + $8 = $16 million, which is less than the $24 million preferred participation cap. So, venture capitalists will get $16 million.
Founders and employees will get $18 million – $16 million = $2 million.

Obviously, venture capitalists will choose option #2 because they will make $1.6 million more.

Scenario #3: Home run outcome for start-up X. It’s sold for $100 million.

Let’s review the two options venture capitalists have.

Option 1: venture capitalists convert all of their stocks to common stock. Since they own 80% of the company, they will get $100 million *80% = $80 million.

Option 2: venture capitalists chooses to take advantage of liquidation preference and preferred participation. They will get

$8 million due to liquidation preference.
Due to preferred participation, they will double dip. ($100 million – $8 million) * 80% = $73.6 million. However, due to the preferred participation cap of $24 million, venture capitalists can only get $24 million in total, including the $8 liquidation preference.

Obviously, it makes much sense for venture capitalists to choose option 1 since they will make a lot more money by converting their preferred shares to common shares. This example demonstrates that liquidation preference and preferred participation are used to protect down side for venture capital investment.

Liquidation preference is very common — almost every venture capital backed start-up has it. However, preferred participation is something entrepreneur would fight very hard to avoid. In today’s economic environment, it’s not uncommon to see 2X or 3X liquidation reference for preferred participation term, which is pretty bad from entrepreneur and employee perspective.

Today’s market is drastically different from the dot com days. Big acquisition or IPO are rare. It becomes even more important for employees to understand the financing terms to make a realistic assessment of the start-up.

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