As part of my consulting work, I sometimes help entrepreneurs prepare to seek angel or venture capital investment. That means helping with business plans, pro forma financials, pitches and pitch decks, and with figuring out what to expect in a term sheet and what all of the technical jargon means. I’m not a lawyer and, if you’re about to accept an offer from an investor, you really need to go over all of the terms with an attorney specializing in these types of deals. However, there is one term that comes up over and over again that new entrepreneurs are not familiar with/don’t understand that has a gigantic impact on the payout an entrepreneur can get when his or her company either fails and closes up shop or succeeds wildly and there is a profitable exit: the liquidation preference.
Again, if you’re looking at a real deal and about to sign some paperwork, go see a lawyer, but here is a basic rundown of what a liquidation preference is and how it affects an entrepreneur.
When you raise money from a venture capitalist, the VC will almost certainly expect to receive preferred stock as opposed to common stock. The holders of preferred stock receive preferential treatment if there is a liquidation event at the business. A liquidation event would be something like the sale of the business, a bankruptcy, or a dissolution of the business. One of those bits of preferential treatment that preferred stockholders receive in one of these events is the liquidation preference. A liquidation preference basically means that the investor who now holds preferred stock will get his or her investment back before the company’s assets are divided up amongst all of the shareholders. So, if an investor puts in $1 million dollars for a 20% equity stake with a 1x liquidation preference and then the company sells for $10 million, that investor first gets his or her $1 million out and then the remaining $9 million is divided among the shareholders based on percentages, so that same investor will get an additional $1.8 million for a total of $2.8 million. Without the liquidation preference s/he would have just received $2 million or 20% of the $10 million sale price.
The same goes if the company ends up selling at a lower valuation or closing its doors and this is actually why the liquidation preference came into existence: to protect the investors in case of such a loss. If the investor put in the same $1 million for 20% but then the company sold for just $2 million – without a liquidation preference the investor would only be entitled to $400,000 and would have to take that loss. With a 1x liquidation preference he or she would receive the $1 million investment back and then the remaining $1 million would be split between the shareholders.
Without a liquidation preference it would be possible for an entrepreneur to make money tanking a company – an investor may put in $1 million dollars for 20% and 1 year later the entrepreneur – who owns 80% – could decide to dissolve the business and take 80% of the money left, essentially screwing the investor. A liquidation preference seeks to more closely align the entrepreneur’s interests with the investor’s.
Liquidation preferences can also come in multiples. The examples above showed a 1x liquidation preferences but investors can also say they want 1.5 times, 2 times, or more of the invested money back first before divvying the rest up by percentages. This is sometimes referred to as a super liquidation preference and is absolutely not the norm, so be incredibly wary if you see this in a term sheet.
As you can see, the liquidation preference can drastically alter the returns an investor or an entrepreneur is entitled to so it’s important to understand what you’re agreeing to before signing on the dotted line and taking an investor’s money. While there are many items in a typical term sheet that can be tricky and easily misunderstood, the liquidation preference is the one that comes as the biggest shock to the vast majority of my clients so I hope this helps provide a bit of clarification.