If you work in the tech industry, you’ve undoubtedly heard the term “liquidation preference” at some point.You may have experienced a chill as the words fell upon your ears, too. There’s a non-medical reason for this: liquidation preferences are created to ensure that investors get paid before anyone at a startup when the company either sells or goes out of business. In short, they’re good for investors and less good for founders, employees or even earlier investors.
Let’s walk through the basics.
Broadly, a liquidation preference determines who gets what when a company is liquidated. This can mean when a company is merged, when it’s sold, when there’s a change of control of the company or when there’s a wind-down.
In all of these scenarios, a company’s liquidator looks at the company’s secured and unsecured loan agreements, along with who owns preferred versus common stock. (Preferred shares are what VCs typically buy to ensure that they’re repaid ahead of holders of common shares.) Everyone on the company’s cap table is ranked after that, and the liquidator distributes the proceeds of a sale accordingly.
Consider the wind-down scenario. Let’s say a company raised both venture capital and venture debt — a loan. Say that as time went on, it began falling behind on its debt payments, and that its VCs decided it was a losing proposition to continue funding the company. If there was any capital remaining — say the company hadn’t burned through every last bit of its funding, or say some money was made from a sell-off of its remaining assets, like its intellectual property — its investors would be paid before anyone at the company saw a nickel.
When the outcome is much better, the same thing basically happens — though who gets how much and when grows more complicated with every new round of funding a company raises. The reason: When investors make a liquidation preference a condition for investing in a startup, they do it in order to claim their part of the profits first. But later-stage investors can demand liquidation preferences that ensure they get paid before earlier investors, too. It’s kind of like a layer cake. They can also demand that they get paid back more than the standard of one times their money back.
Why would startups agree to these seemingly onerous terms? Well, sometimes, they don’t have any choice. They take the terms, or they go out of business. Sometimes, startups wanting unicorn status will agree to the terms for a richer valuation, thinking it will attract press, customers and employees. Whether it’s worth the gamble takes time to play out. But certainly, things can get ugly when these same companies get sold rather than go public (a process that converts everyone’s shares to common shares). It’s uglier still when they sell for less than expected, the investors take their cut, and there’s little to nothing left for founders and employees.
Not every deal involves liquidation preferences. You don’t typically see them in early-stage deals. You don’t seem them in deals where a company has been created by a founder whom VCs trip over themselves to fund. But they do start to appear as a company matures. (For some context, in recent quarters, senior liquidation preferences have been showing up in between 25 and 35 percent of deals, according to the law firm Fenwick & West, which studies these things.)
You also see liquidation preferences start to spike when a business cycle turns, and they can get pretty egregious. After the big boom and bust of the late ’90s, for example, investors who’d earlier settled for one times their money back put the screws to founders out of nervousness and began demanding up to 10 times their return before anyone else got paid in an exit event.
Today’s deals aren’t quite so extreme, but don’t be fooled. Investors are sophisticated. A report published last year by Fenwick & West suggested that, in some cases, unicorn companies’ valuations could fall 80 percent in value, and investors would still get their money back.
The harsh reality is that in many cases, liquidation preferences are a necessary evil. VCs have to protect themselves or they, too, will be put out of business by their own investors. If you begrudge them their protections, you shouldn’t. There are plenty of ways that they can still lose out, particularly in a broader downturn. You can read about one way right here.
Note that we’re just scratching the surface here. If you’re interested in learning more about liquidation preferences, which can be both fascinating but insanely complicated, we also suggest this post by venture capitalist Brad Feld, and this one by Fred Wilson. Both are a little dated at this point, but they’re as relevant today as when they were written.