Understanding liquidation preference

A “liquidation preference” is startup financing lingo for preferred treatment in case of a trade sale. In practice there are different amounts of liquidation preferences (e.g., 1x, 1.5x, 3x) as well as “participating” and “non-participating” liquidation preferences.

Example

A Series A round investor invests USD 10m at a pre-money valuation of USD 50m (~17% ownership). The investor gets a 1x participating liquidation preference.

Let’s assume that the company is sold for USD 100m one year later. The pay-out will be as follows: The first USD 10m directly go to the A round investor. The remaining 90m are split according to the percentage each shareholder owns. This means another USD 15m will go to the A round investor, who in total gets USD 25m even if they only had an ownership of 17%.

Note: If the liquidation preference in this example were “non-participating”, the pay-out would be as follows: As before, the first USD 10m directly go to the A round investor. After this is paid, the existing investors will be paid until their amount of the pay-out equals 83%. This means that the next 49m will go to the existing investors. Last but not least, the remaining 41m are paid out according to each owner’s shareholdings (USD 7m to A round investor, 34m to existing investors). In conclusion, the A round investor get ~USD 17m, existing investors get ~83m.

Background of liquidation preference

Why is there a liquidation preference anyway?

Let’s assume a business angel pays USD 1m into your early stage company that has a pre-money valuation of USD 4m. As a founder, you could sell the company the next day for USD 1m (which is the value of the cash on your bank account), and walk out with USD 800k (you will get by now that you own 80% of the company after the investment).

No serious entrepreneur would ever do this. But still, investors have a point if they say that the first money that ever gets paid back should go to them.

Recommendation

Our strong view on liquidation preference is to go for 1x non-participating. This clause provides basic protection for the investor, but keeps things clean and interests aligned.

It is important to know that the agreed terms are very often continued in future financing rounds. So if you go for 1x non-participating in your seed round, chances are good that this will also be the case in your A+ rounds. This is not only in the best interest of the founders, but also of early stage investors: Inexperienced angel investors do not always realize that aggressive liquidation preferences – the sorts of 2x or 1x/participating – often play out against them over time.

Further reading

Liquidation preference is one of various key terms that should be considered in a term sheet. Phase 5f provides in-depth insights into these clauses, including free templates to download.