Liquidation Preferences – VC and Founder’s Insights
Despite well-reported difficulties, the UK remains the world's third-largest start-up economy on the basis of capital invested each year. Early-stage investment from private individuals, family offices and venture capital funds can be the rocket fuel that ambitious founders require to disrupt industries dominated by established incumbents.
Investments in start-up companies are not without risk, but the potential rewards for finding the right company at the earliest stage can be significant. As a consequence, investors in early-stage companies employ various mechanisms to protect their ‘downside risk’ in the event that things do not go as planned. One such mechanism is the use of Liquidation Preferences.
In this article, we briefly explore the different types of Liquidation Preferences and the varying impact that they can have on investors and founders when it comes to an exit.
What are Liquidation Preferences?
Liquidation Preferences protect investors by determining the priority of distribution, ensuring that they are paid back before ordinary shareholders, such as the founders or employees, in the case of a liquidation event (such as a sale of shares or business assets, or an IPO).
Without Liquidation Preferences, the proceeds of a liquidation event are distributed in the ordinary course - pro-rata among all shareholders (investors and others), in accordance with their percentage holdings in the company. Whilst this may be the fairest distribution, it is likely to be viewed as unattractive by early-stage investors, given the heightened risks associated with early-stage investment.
No Liquidation Preference - Example
Consider the example of Startup Co Ltd, a company that has been sold to Established Co Ltd, for £10m.
In its first year of trading, Startup Co Ltd raises £5m via a Series A round from VentureCo LP, in exchange for a 40% shareholding, with no liquidation preference rights attached to the VentureCo shares.
The other shareholders in Startup Co Ltd are the founders, holding the remaining 60% of its shares.
In this scenario, VentureCo LP would receive £4m of the £10m exit proceeds, resulting in a loss of £1m to the fund. The remaining £6m of proceeds would be shared among the other shareholders, pro-rata to their shareholdings.
Types of Liquidation Preference
Generally, there are three categories of Liquidation Preference:
- Non-Participating
- Participating
- Capped
Non-Participating Preferences
Employed as a downside-only protection, Non-Participating Preference shares allow investors to choose between (i) exercising their option to recoup their original investment before the payment of other investors, or (ii) share equally in the proceeds of a liquidation with ordinary shareholders.
Most commonly, investors holding Non-Participating Preference shares will enjoy a 1x liquidation preference, meaning that they receive a pound-for-pound preference on liquidation, up to the value of their initial investment. Depending on the circumstances, however, investors may demand higher (1.5x/2x) preferences. The example scenarios below assume a 1x liquidation preference.
Non-Participating Preference - Example 1
Again, Startup Co Ltd has been sold to Established Co Ltd for £10m. In its first year of trading, Startup Co Ltd raises £5m via a Series A round from VentureCo LP, in exchange for a 40% shareholding, with non-Participation Preference Rights attached to the VentureCo LP shares.
In this scenario, VentureCo LP would exercise its Liquidation Preference rights (as the company has been sold at a value less than its investment valuation), meaning that the investor would be paid out before the other shareholders, but would receive no additional funds aside from the amount of its preference. Consequently, VentureCo LP would recover its £5m investment (incurring no loss to the fund), with the remaining £5m shared among the remaining shareholders pro-rata.
Non-Participating Preference - Example 2
Consider the situation where Startup Co Ltd is sold to Established Co Ltd for £20m, rather than £10m.
In this scenario, VentureCo LP would not exercise its Liquidation Preference rights and instead convert its preference shares to ordinary shares, meaning that it would participate pro-rata alongside the other shareholders. Consequently, VentureCo LP would receive £8m on the share sale for its 40% stake, securing a £3m profit.
Participating Preferences
Similarly to Non-Participating Preference Shares, Participating Preference shares allow investors to receive their investment back before the other shareholders participate. However, they also allow the investor to participate alongside the other (non-preference) shareholders in the post-preference distribution. This means that the investor receives a fixed return (i.e. their investment amount) plus a share of the remaining proceeds that are distributed pro-rata between all the shareholders (including the investor).
Participating Preference - Example
Once again, Startup Co Ltd has been sold to Established Co Ltd for £10m. In its first year of trading, Startup Co Ltd raises £5m via a Series A round from VentureCo LP, in exchange for a 40% shareholding, with Participating Preference Rights attached to the VentureCo LP shares.
In this scenario, VentureCo LP would first recover its £5m investment, and then receive 40% of the remaining £5m to be distributed among all the shareholders. Consequently, VentureCo LP would receive £7m in total, resulting in a profit to the fund of £2m on its original investment. The remaining £3m would be shared among the other shareholders, pro-rata.
Capped Preferences
Finally, there are Capped Preference shares, which are similar to Participating Preference shares in that they allow the investor to first recover their investment and then ‘participate’ in the pro-rata distribution, but are subject to a limit on the post-preference participation. These may help address some of the perceived unfairness that results from non-capped Participating Preferences from the perspective of Ordinary Shareholders.
Capped Preference - Example
Once again, Startup Co Ltd has been sold to Established Co Ltd for £10m. In its first year of trading, Startup Co Ltd raised £5m via a Series A round from VentureCo LP, in exchange for a 40% shareholding, with Capped Preference Rights attached to the VentureCo LP shares, permitting a maximum distrubution of £6m to the preference shareholders .
In this scenario, VentureCo LP would be paid out before the other shareholders, and would participate in the post-preference distribution (subject to the cap). Therefore, in this scenario, VentureCo LP would first recover its £5m investment and then receive an additional 40% of the remaining £5m to be distributed, capped to a total of £6m. Therefore, VentureCo LP would receive £1m of the post-preference distribution (all profit to the fund), with the remaining £4m shared among the other shareholders.
Comparison
As discussed, investing in early-stage companies often comes with a higher risk than investing in ‘established’ companies, but may also result in significantly greater returns. As demonstrated above and illustrated below, how investments are structured can significantly impact the returns available for investors and founders alike. Consequently, it is imperative that investors and founders understand, negotiate and employ the best equity structure for their respective interests.
Hunters Corporate and Commercial
Hunters Law's Corporate and Commercial Department has extensive knowledge and experience advising founders and investors in early-stage companies. Get in touch to discuss how to best structure your company and protect your investments.
