Protecting your investment: liquidation preferences explained
By Abdullah Mutawi, Partner and Oli Denne, Senior Associate
Early-stage venture capital investments are at the higher risk end of the risk vs reward spectrum. Anyone investing in this asset class knows that most start-ups fail. But if they do pick that one-in-a-million unicorn, their early investment will most likely generate a significant return.
Mindful of the risks involved, VCs rely on an array of methods to mitigate the risk to the value of their investments. One notable approach is the use of liquidation preferences. In this article we discuss the use of liquidation preferences, including examples to clarify their role in risk mitigation.
What are liquidation preferences?
As valuations rise with each funding round, investors seek assurance that they'll receive a return of at least the amount of their investment upon selling their shares. Liquidation preferences provide a mechanism to prioritise these investors over other shareholders under specific circumstances.
Triggered by a 'liquidity event', liquidation preferences typically apply in cases such as:
- a trade sale (whether structured as a share or asset sale)
- a winding up
- (less commonly) an IPO.
The three key ‘moving parts’ of liquidation preference mechanisms are participation, seniority, and multiple.
Participation
Participating liquidation preference
In a participating liquidation preference, the investor recoups their capital investment before other shareholders and then shares the remaining proceeds with them proportionally. This is sometimes referred to as a 'double-dip' preference.
For example, an investor acquires 100,000 preferred shares for $1 million, resulting in a 50% stake in the start-up. The investment terms include a participating liquidation preference equal to the $1 million investment. If the start-up underperforms and sells all its shares to a private equity investor for $1.5 million, the investor with the liquidation preference would receive its $1 million in priority to other payments, and would then participate pro-rata in the remaining $500,000 resulting in a total return of $1.25 million.
Without the preference, the investor would only receive $750,000 (50% of the purchase price).
Non-participating liquidation preference
A non-participating liquidation preference offers investors the option to either recover their entire capital investment or share liquidity event proceeds with all shareholders proportionally. Non-participating preferences are sometimes referred to as 'downside only' protection because an investor who is paid out under a non-participating liquidation preference will never return more than the amount of their original investment.
Investors will choose the option yielding the largest returns. This preference is more balanced, as it doesn't grant investors two separate distributions as in participating preferences. It is therefore the more common of the two approaches.
Using the previous example, where a $1 million investment grants a 50% stake in the start-up, and the shares sell for a total valuation of $1.5 million, the investor faces two choices: either exercise the liquidation preference and receive a guaranteed $1 million or convert their preferred shares to ordinary shares for $750,000 (50% of $1.5 million).
While the choice seems clear, if the company sells at a higher valuation than anticipated, the investor may opt for their pro-rata share of the consideration instead. The choice can become particularly difficult where the consideration is structured as a mixture of cash and shares, or where a portion of the consideration is contingent or deferred.
$1.5 million proceeds
$3 million proceeds
Scenario one illustrates the scenario described above – as shown, the participating preference delivers a much more favourable outcome to the investor. If the investor holds a non-participating preference, they are still better off opting for the preferred return. This changes in scenario two, where the deal value has increased to $3 million – here the investor's non-participating preference is less valuable that its pro-rata share, so the investor would of course opt to receive its pro-rata. A participating preference still delivers the most favourable outcome to the investor.
Seniority
Understanding seniority structures is crucial for entrepreneurs and venture capitalists when investing, as they determine their payout position and timing. Although pari passu structures were once prevalent, standard seniority structures have gained popularity in recent years.
Standard seniority
In general, new equity-round investors in venture capital funding are offered preferred shares with superior economic and voting rights. As a result, liquidation preferences can be 'stacked', with payouts ordered from the latest to the earliest round.
This standard 'last in, first out' approach ensures each new funding round investor receives their payout before preceding round investors. The risk for founders and early-stage investors is receiving little or nothing if liquidity event proceeds are insufficient and senior liquidation preferences exhaust the available funds before junior preference holders realise a return. Ultimately, in such a scenario, the investors will only have returned all or part of the amount of their original investment, so no one walks away feeling particularly happy.
Pari passu seniority
Pari passu liquidation preferences grant equal seniority status to all preferred shareholding investors. This ensures every investor receives a portion of the proceeds, preventing anyone from being left empty-handed. Payments under a pari passu structure are typically weighted to the amounts invested by the preferred investors rather than paid out pro-rata, to ensure a more proportionate allocation of available funds between them.
Tiered seniority
This hybrid liquidation preference combines standard and pari passu seniority, arranging investors from various funding rounds into distinct seniority levels or 'tiers'. Each tier is treated as a separate class concerning liquidation seniority, with the standard seniority approach applied to each tier. Within each tier, investors are paid following the pari passu format.
Return multiples
A 1x multiple ensures the investor recovers 100% of their investment. While the market standard for liquidation preference typically grants investors a 1x liquidation preference, certain situations may prompt investors to request a multiple of their invested capital.
In such cases, an investor may request a 2x or 3x multiple upon a liquidity event. Although 2x or 3x multiples might be acceptable in rare circumstances, such as insolvency rescue funding or a particularly challenging financing environment, the market standard in the Middle East (and in the US and UK) remains a 1x liquidation preference.
