Countering Liquidation Preference

It is fairly common for investors to ask for Liquidation Preference rights. However, as an entrepreneur, you need to be very careful about these and negotiate them well, keeping long term implications in mind.

Let’s understand what these clauses are, and how you could possibly negotiate the same, to make it a win-win proposition.

Liquidation Preference Clause
So, what does this clause mean?
If we simplify the jargons, it means that the investor is first paid (either 1x or sometimes 2x their investment amount –subject to negotiations), before paying the others, at the time of a liquidity event.

Let us understand the mechanics through an example
If a company is sold for $100 million and the Investor had put in $10 million for a 25% stake, a 2x participating liquidation preference deal will fetch them $40 million—which is two times the investment plus 25% of the remaining $80 million. The existing investors would receive $ 60 million.

This is a good clause to protect the investor and assures them of the return. But it could work disproportionately in the favour of the investor, in case the company achieves significant exit value, wherein it is primarily due to the efforts of the entrepreneur / founder.

What I would therefore suggest to entrepreneurs/founders is to agree a target return amount and basis the same negotiate a full catch-up clause once the investor has achieved their return.

Let’s understand this with an example Assume that the exit is happening after 4 years. Therefore, the investor is entitled to receive the first $20 million on exit ($10 million of original investment and 25% x 4 years, i.e. 100% or another $10 mn for the target return). Thereafter, the existing investors would get full catch-up. So, for a 25% equity stake, if the investor has received $20 million, the existing investors would receive thereafter $60 million (20mn / 25% x 75%). Thereafter, from the balance $ 20 million, everyone receives distribution in the ratio of their shareholding. Effectively, the investor would take home $25 million and the existing shareholders $ 75 million.

Therefore, from a founder’s perspective, they would retain $ 15 million more, on the transaction. And hence this becomes a million dollar advise!!!