Beware the trappings of liquidation preference

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

A reader asks::  I’m the co-founder and CEO of an e-commerce startup, and I’ve been meeting with different VC firms regarding an initial round of funding.  I’ve started doing some reading on term sheets and the issues we will need to address and I’m a little confused with some of the VC terminology.  Could you please explain to me what a liquidation preference is and how we should negotiate it?

Answer: Welcome to the world of venture capital.  A liquidation preference is one of the essential components of preferred stock and is generally considered to be the second most important deal term in a VC investment (the first being the company’s valuation prior to the investment, commonly referred to as the “pre-money valuation” or “pre”).

Let’s start with the basics:  A VC investor will be issued shares of preferred stock, not common stock.  Preferred stock, as the name suggests, is preferable because it grants certain key rights to the holders – making it far more valuable than common stock.  One of those rights is a liquidation preference.

The word “liquidation” is broadly defined in VC documentation to include not only the actual liquidation of the company (i.e., the disposition of the company’s assets) upon dissolution or bankruptcy, but also the sale of the company (whether via stock, assets or merger) to a third party or a change of control.

The word “preference” flows from “preferred” and means the shares of the preferred stock will have a priority over (or ‘be treated better than,’ if you prefer) the common stock in the event of a liquidation.  For example, in bankruptcy, once the company’s creditors have been paid off, any remaining assets would be distributed to the holders of the preferred stock before common stock shareholders see a dime.

Similarly, if the company were sold, the proceeds of the sale would be distributed first to the holders of the preferred stock and then to the holders of the common stock, based upon the terms of the liquidation preference.

There are three types of liquidation preferences:

• Straight (or non-participating) preferred – This liquidation preference is most favorable to the company.  Upon the sale of the company (or any other liquidation), the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders.Alternatively, the preferred stockholders could choose to convert their preferred stock to common stock and simply be treated the same as the common stockholders (letting them share ratably in the proceeds).

• Participating preferred – This liquidation preference is most favorable to the investor (and is sometimes referred to as “double-dip preferred”).  Similar to straight preferred, the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders.However, the preferred stockholders would then also be treated like common stockholders and would share ratably in the remaining proceeds –in effect, being paid twice (or “double”).  Issuing participating preferred has the same economic effect as issuing a promissory note and shares of common stock (or a warrant) to the investor.

• Capped (or partially) participating preferred – This liquidation preference is often viewed as an intermediate approach.  The preferred stockholders have the same rights as participating preferred (i.e., return of investment, plus share ratably in the reminder), but their aggregate return is capped. Once they have received the capped amount, they no longer have the right to share in the remaining proceeds with the other common stockholders.

Participating preferred is generally the exception (about 20 percent of the deals today) — particularly in the initial (“Series A”) round of funding.  Push hard for a straight preferred liquidation preference and settle for capped participation as a fallback position.  Remember, whatever you agree to with your initial investors will carry forward to future rounds. That’s why participating preferred is best avoided.

As part of the negotiation of liquidation preferences, there is also a concept called a “multiple” (e.g., “2X multiple,” 3X multiple,” etc.).  Watch out for this one. It means the preferred stockholders are entitled to a multiple of their original investment (double or triple the amount) before the common stockholders get anything.

So, before you agree to any participating preferred and/or multiples, you should require the VC to run spreadsheets/models demonstrating how much you and the other founder(s) will receive based on various sales price scenarios.

For example, if your company were sold for $40 million, and the VC had invested $5 million for one-third of the company, with a 2X participating preferred, the VC would receive $10 million off the top (not including any accrued dividends, if applicable), plus another $10 million (one-third of $30 million), for a total of $20 million.

The VC would thus receive 50 percent of the sale proceeds even though it only owned one-third of the company. Be safe: Do the math.

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.