How Does Liquidation Preference Work?
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How liquidation preferences work?
A liquidation preference is the right of an investor to recover the amount of her investment if the company is sold or undergoes some other exit event, such as a public offering. Basically, it gives the investor priority of payment from proceeds of a sale of the company. Sometimes the liquidation preference is a multiple (1x, 2x, 3x, etc.,) of the amount invested. To understand the liquidation preference, it is important to understand how this right works in concert with conversion and participation rights.
The Liquidation Preference
Investors place money in a company with the expectation of making a profit when the company later sells, goes public, or the investor’s interest is purchased during a later round of equity financing. The liquidation preference makes certain that the investor does not lose her investment at the expense of other equity owners when the company is sold. Here is an example:
Tom invest $100,000 dollars in a company for 10% ownership. Without this investment, the company would shutter and be worth nothing. Three months later, the company is doing well and a strategic purchaser buys the company for $750,000. Without a liquidation preference, Tom would receive $75,000 from the sale. Basically, his money was used to save the company and make a profit for the existing owners. If Tom held a 1x liquidation preference, he would have received a return of his $100,000 at the time of sale. If he had a 2x liquidation multiple, he would receive $200,000 before anyone else in the company received any of the proceeds from sale.
The Liquidation Preference and Participation Rights
Participation rights allow an investor to receive a distribution from the company any time other equity owners receive a distribution. This normally applies to startups when some amount of equity in the business is sold to bring cash into the business. This is common when investors seek to be cashed out of the business. The investor’s distribution would equal her ownership interest in the company.
For example, Tom invests $100,000 for 10% of the business. The company decides to sell 50% of the company’s stock (either existing stock of current investors or issuance of new stock) to a new investor for a profit of $1 million. If proceeds rom the sale are distributed to existing shareholders, Tom would receive $100,000 or 10% of the value of the stock sale. This protects Tom from the situation where other investors cash out of the company and leave Tom out of the deal.
This same scenario applies when the entire company is sold. In such a scenario, Tom would receive his liquidation preference as compensation at the time of sale. If he has a 3x liquidation preference, he will receive $300,000 from the sale. But, what if the company sells for $5 million? Obviously, Tom would want to participate in the amount of distribution above his liquidation preference of just $300,000. So, Tom will reserve participation rights at 10% of profits beyond his liquidation preference. Normally, all other equity holders would receive a distribution to match his liquidation preference amount before Tom would further participate at a 10% rate. This is known as “catching up”.
When combined with a liquidation preference, participation rights may be either unlimited or capped at a certain amount or certain percentage. An unlimited participation right would allow Tom to recover his liquidation preference at then participate in any distributions at his 10% ownership rate. If there were a $2 million dollar cap in place, after receiving his liquidation preference, Tom would only participate in receiving 10% of $2 million. If the company sold for $5 million, he would not participate in the additional $3 million distribution.
Tom would certainly love to receive a liquidation preference and participation rights. Unfortunately, investors rarely receive a liquidation preference and uncapped participation rights.
The Liquidation Preference and Conversion Rights
Investors generally receive preferred shares in the company in exchange for their investment. The preferred shares provide the investor with preferred benefits, such as a liquidation preference and participation rights. Investors also routinely secure rights that allow them to take advantage of the most advantageous scenario: being a common shareholder at 10% with no liquidation preference, or being a preferred shareholder with a liquidation preference and capped participation rights. This is accomplished through “conversion rights”.
Conversion rights allow the investor to convert her preferred shares into the equivalent ownership percentage of common shares. The common shares do not have a liquidation preference or participation rights. The benefit of this scenario arises when common shareholders will receive a greater benefit than an investor with liquidation preference and participation rights. For example, Tom owns 10% of a company with a 3x liquidation preference and participation rights up to $2 million (assuming no catch up by other investors). If the company is sold, Tom would receive $300,000 in liquidation preference, plus $200,000 of participation rights. This is a large benefit over other 90% equity owners who receive the remaining $1,500,000. But, what if the company sold for more than $5 million. At $5 million sale price, the other 90% equity owners would receive an equivalent percentage value of Tom or $4.5 million. If the company sells for more than $5 million, Tom would be better off converting his preferred shares to 10% ownership of common shares.
As you can see, a liquidation preference is a simple concept, but it rarely exists on its own. Combining the liquidation preference with participation and conversion rights is to be expected in a preferred equity financing deal.