Liquidation Preference: Safeguarding Investments in Turbulent Waters

  • Written Written by Ali Kidwai 18 January 2024 | 4 min read
  • Editor's Note :

    Explore the concept of liquidation preference. As startups and investors navigate the complex landscape of equity financing, understanding the implications of liquidation preference is paramount. This blog serves as a valuable resource, offering both clarity and depth on a topic that plays a pivotal role in shaping the dynamics of venture capital transactions

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Successful startups often measure their success by achieving an exit strategy that ensures a favorable return for their stakeholders. Unfortunately, many startups fall short of reaching this milestone.

Whether your organization will be one of the lucky few, it must know what founders and other stockholders are owed when it gets acquired or has another type of liquidation event. The principles that regulate the allocation of equity following a company's exit are referred to as "liquidation rights and preferences."

In this blog post, we'll dive deep into the concept of liquidation preference, exploring its implications for investors and entrepreneurs.

What is Liquidation Preference?

Liquidation preference is the second most crucial factor for venture capital investors. The first is a company's pre-money valuation. Liquidation preference is vital because it determines who gets paid first and how much. It applies to startup organization going bankrupt, choosing to sell, or going through other liquidation events.

liquidation preference

Source: Investopedia

The liquidation preference typically consists of a contractual clause found in agreements between a venture capital investor and an early-stage startup. These preferences provide preferred shareholders priority over common shareholders and debtholders in the distribution of funds resulting from the potential sale or closure of the early-stage company.

Navigating the Types of Liquidation Preferences

Non-Participating Preferred Stock: In a non-participating liquidation preference, investors are entitled to receive the initial investment amount (the liquidation preference) or the amount received by common stockholders, whichever is greater. Once the investor gets the predetermined liquidation preference, they do not participate in the remaining distribution of proceeds.

Participating Preferred Stock: On the other hand, participating preferred stockholders have the right to both the liquidation preference and a share of the remaining proceeds distributed to common stockholders. This participation feature benefits investors from the upside if the company is sold at a higher valuation. 

Let's illustrate this with an example. Supposing an investor holds $5 million in participating preferred stock with a 2x liquidation preference and the company is sold for $20 million, the investor would first receive $10 million (2x liquidation preference). The remaining $10 million would then be distributed among all shareholders, with the participating preferred stockholders receiving an additional share. In this way, participating preferred stock provides a level of protection while still allowing investors to share in the success of the exit.

Liquidation Preference Multiple: The term "multiple" denotes the share that the venture investor is set to receive before the company's founder and employees. This share can be at a 1X, 2X, or 3X multiple.
Capped: This type of preference is equally advantageous for the organization and the investor. Although the investor grasps the concept of double-dipping in a participating preference, the returns are limited by a cap. That's why this is sometimes called the "partially participating preferred.

Understanding the Mechanism of Liquidation Preference

In venture capital, investors frequently seek to secure their financial position by establishing a liquidation preference, ensuring priority payouts ahead of other investors, common shareholders, and debtholders. Given the inherent risks in venture capitalism, this contractual safeguard serves as a means for investors to mitigate potential losses and fortify their financial interests.

mechanism of liquidation preference

While bankruptcy becomes relevant in the context of liquidation preferences, it's not the only situation where they're used. These clauses are also implemented during times such as:

When these issues happen, the early-stage investors will get their share of the proceeds before shareholders with common stock.

If the preference involves multiple options, the distribution of proceeds occurs at 1x, 2x, or 3x the original issue price (OIP) of the preferred shares. The OIP represents the initial amount paid by the investor for the preferred stocks. Under typical terms, the OIP is multiplied by the total number of outstanding shares.

Real World Instances of Liquidation Preference in Action

In India, as in other countries, liquidation preference implementation and impact can vary based on the terms negotiated between investors and the company. Here's how liquidation preference works with real-world examples from Zomato, Flipkart, and Quickr:

Zomato

zomato logo

Source: Google

In Zomato's Series J funding round in 2021, certain investors received 1x liquidation preference. If the company were to liquidate today, these investors would get their invested capital back before any common shareholders receive anything. This incentivizes these investors to provide funding as they have a higher priority claim on the organizations assets in case of a negative outcome.

Flipkart

Flipkart logo

Source: Google

Flipkart's Series C funding round in 2010 involved multiple investors with varying liquidation preferences. Some investors had a 1x preference, while others had a higher 2x preference. In liquidation, the 2x preference investors would receive twice their invested capital before the 1x preference investors receive anything. Common shareholders only receive any remaining assets after all preferred shareholders are paid out.

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Quickr

quikr logo

Source: Google

Quickr's 2015 acquisition by OLX involved a complex liquidation preference structure. Different investor classes had varying preferences, ranging from 1x to 3x, depending on their investment stage and risk profile. This structure ensured that earlier investors, who took on more risk by investing in the company early, received a proportionately higher share of the company's remaining value in case of liquidation.

Parting Thoughts

Therefore, for startup investments, liquidation preference is a critical element that shapes the financial outcomes for investors and entrepreneurs. While it provides a safety net for investors, entrepreneurs must navigate the potential dilution and loss of control associated with this financial clause. Striking a balance between downside protection and alignment of interests is essential for fostering a healthy and sustainable relationship between investors and founders.

As the startup ecosystem evolves, understanding and negotiating liquidation preferences will remain essential for all parties involved in the journey from inception to exit.

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