Liquidation Preference Basics

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.

Mexico’s Entrepreneurial Ecosystem Interview 1 – Jorge Madrigal: Founder & CEO, Aventura

When I started to research the entrepreneurship scene in Mexico I immediately discovered Jorge Madrigal. He’s the Founder and CEO of Aventura, runs numerous startup events in Mexico City including Apptualizate and Tech Startup Nights, and has been interviewed for and contributed to The Next Web. Lucky for me, he’s also a friend of a friend of mine. When I asked for an intro from that friend I was informed that,

“Jorge is entrepreneurship in Mexico,”

so I was extremely excited that he agreed to let me pick his brain about the Mexican startup scene.

Naturally, the first thing I wanted to know was how Jorge got into the startup scene in Mexico in the first place. Born and raised in Mexico, Jorge went to the U.S. for college where he joined his school’s entrepreneurship club. The faculty adviser often spoke about how international students come to the U.S. and then never return to their home countries to “fix things.” Jorge didn’t want to be one of those people and believed that Mexico had a lot of potential, so he returned to Mexico looking for a job in private equity but ended up at an angel fund instead. Here he says he learned how far behind entrepreneurs in Mexico really were as compared to their counterparts in the U.S.

As Jorge sees it, Mexico has plenty of people with a lot of money, but they don’t necessarily want to invest it in helping someone else build a company. At the same time, U.S.-based investors are open to investment in Mexican companies, but there just isn’t enough deal flow to make them sit up and notice. Despite all of the hype about access to capital as a key issue, Jorge sees it differently. He says,

“If you have 20,50, 100 companies doing interesting things, money will come.”

When Jorge asks investors to come to Mexico City to work with his startups they’re happy to, but they ask him to deliver a certain number of interesting companies/potential deals for them within their investment niche and he simply can’t do it.

And the #1 reason there isn’t enough deal flow? According to Jorge, the most important thing lacking is a community of entrepreneurs and support for their endeavors. He doesn’t see people sharing and developing a sense of community despite major investment from the government including the creation of clusters, incubators, accelerators, etc. As Jorge sees it, these efforts are falling short because the government is attempting to copy other countries’ models but,

“Mexico has Mexican problems [to overcome] – not Chinese problems or U.S. problems – problems that are innate to Mexico. The biggest mistake,” according to Jorge,” is trying to do things exactly as they’re done in other countries.”

One of those “Mexican issues” that Jorge identifies is that entrepreneurship is not accepted as a legitimate career choice. In fact, it’s often seen as a euphemism for not having a job. This is partly because there are not enough Mexican entrepreneurs serving as role models to show how you can actually make a great living through entrepreneurship and partly because the Mexican family is more economically dependent on all of its members across multiple generations than in, say, the United States, so the decision to try a startup will likely affect an entire family, not just the individual entrepreneur. Plus, when a young person is still living with his/her parents (which, different from the U.S., is often true until s/he gets married) it can be much tougher to break from this disapproval and give a startup a chance.

Another issue that Jorge points out is the greater socio-economic stratification present in Mexican society. The networking opportunities, education, or money to be able to take the first steps into entrepreneurship aren’t readily available to everyone. This is one reason that all of the events Jorge hosts for current and aspiring entrepreneurs are free. A typical event like his, but hosted by another organization, would cost 700 – 1,000 pesos, he says. That’s less than $100 USD (at the high end), but for a young person making maybe $500-$700 USD per month, it’s a big expense if they’re not yet sure if entrepreneurship is right for them. In fact, Jorge says,

“For me, this whole entrepreneurship thing is really about creating more social mobility in Mexico.”

His efforts are certainly working. When Jorge began hosting events less than 2 years ago he was able to pull in just 45 attendees in a metropolitan area of well over 20 million people. Now, he’s able to attract more than 200 attendees per month. He’s also successfully helped students at 3 universities start entrepreneurship clubs to start getting young people thinking and talking about entrepreneurship and building the next generation of the entrepreneurship community.

So, with all of the efforts that Jorge and others are making to develop Mexico’s entrepreneurship community and all of the potential that the country has, where does he see the Mexico City startup scene in 5 – 10 years? “I don’t know,” he says.

“The thing I fear the most is …that our tech entrepreneurship community doesn’t get to the point that if the current promoters quit or leave the whole thing won’t die.”

But for now anyway, Jorge will hold down the fort in Mexico City trying to build a more robust tech startup ecosystem and to develop the next generation of Mexican entrepreneurs.


Do you have experience in the Mexico City startup scene? If so, please let me know your thoughts on what Jorge had to say in the comments sections below. Our next interview will be with Joshua Ford of Endeavor Mexico.