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Liquidation Preference

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What is Liquidation Preference?

Liquidation preference is a term used in venture capital and private equity agreements that specifies the order and amount of payments to investors in the event of a liquidation event, such as the sale, merger, or dissolution of a company. It ensures that investors receive their initial investment back (or a multiple of it) before any remaining proceeds are distributed to other shareholders, including the founders and employees.

How Liquidation Preference Works

Liquidation preference dictates the hierarchy of payouts when a company undergoes a liquidation event. There are typically three types of liquidation preferences:

  • Non-Participating Preference: Investors receive their initial investment or a specified multiple of it first. Any remaining proceeds are distributed to other shareholders.
  • Participating Preference: Investors receive their initial investment or a specified multiple of it first, and then they also participate in the remaining distribution alongside other shareholders.
  • Capped Participating Preference: Similar to participating preference, but with a cap on the total amount investors can receive.

The terms of the liquidation preference are outlined in the company's charter and are agreed upon during the investment negotiations.

Example

Consider a scenario where a company is sold for $50 million. The company had previously raised $10 million in venture capital with a 1x non-participating liquidation preference. This means the investors are entitled to receive their initial $10 million investment back before any other shareholders receive proceeds.

  • Non-Participating Preference: Investors get $10 million. The remaining $40 million is distributed among other shareholders.
  • Participating Preference: Investors get $10 million plus their share of the remaining $40 million alongside other shareholders.
  • Capped Participating Preference: Investors get $10 million plus their share of the remaining $40 million, but the total they can receive is capped at a specific amount.

Advantages

Liquidation preferences provide protection for investors by ensuring they recover their initial investment or a multiple of it before other shareholders receive any proceeds. This can make investing in startups less risky and more attractive, as it offers a degree of downside protection.

Disadvantages

For founders and other common shareholders, liquidation preferences can reduce the amount they receive from a liquidation event. High or multiple liquidation preferences can significantly diminish the returns for these stakeholders, especially if the company is sold for a lower-than-expected price.

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Related Terms

Adjusted EBITDA

Adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a financial metric used to assess a company's operational performance. It modifies the standard EBITDA by excluding non-recurring, irregular, or non-cash expenses to provide a more accurate reflection of ongoing profitability.

Angel Investors

Angel investors are affluent individuals who provide capital to startups or early-stage companies in exchange for equity ownership or convertible debt. These investors often offer not only financial support but also valuable business expertise and mentorship.

Anti-Dilution Provision

An anti-dilution provision is a clause in an investment agreement that protects an investor from dilution of their ownership percentage in the event that new shares are issued at a price lower than the investor originally paid. It is commonly included in venture capital and private equity agreements.

Bootstrapping

Bootstrapping in business refers to starting and growing a company using personal finances or the company’s operating revenues, rather than relying on external funding or venture capital. Entrepreneurs use their own resources and reinvest profits from initial sales to fund further growth, emphasizing financial independence and careful cash flow management.

Bridge Loan

A bridge loan is a short-term loan used to meet immediate financing needs while waiting for more permanent funding. It serves as a temporary solution to bridge the gap between the need for funds and the availability of long-term financing.

Cap Table

A Cap Table, or Capitalization Table, is a detailed spreadsheet or document that outlines the equity ownership, types of shares, and ownership percentages of a company. It includes information on founders, investors, and employees, as well as the dilution of shares over time through various funding rounds and option grants.

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