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Liquidation Preference. In very simple terms: "Liquidation Preference" is an agreement between a company and an investor that when the company is acquired or

by cj 7y ago

Liquidation Preference. In very simple terms: "Liquidation Preference" is an agreement between a company and an investor that when the company is acquired or IPOs, the company will pay the investor some specific amount of money BEFORE any other shareholders get paid. If the company negotiated the funding well, the liquidation preference might be 1x (basically saying the company promises to pay back, in full, the investor's original investment if the company is ever sold) Things get scary when the liquidation preference creeps up to 2x, 3x, or higher. It's possible to raise $5mm with a 3x liquidation preference... which means that the investor will get $15mm payout BEFORE any other shareholders in the event of an exit (which means that, after raising that $5mm, the company can not have an exit less than $15mm without 100% all the proceeds going to the original investors). Raising $5mm with a 3x liquidation preference, then selling your company for $15mm, is an easy example of how (even founders) can walk away with $0 after a $15mm sale.

ethanjinsen 7y ago
So in your example, the investors are basically getting a 300% return if the company sells for 15M or more?
- deleted 7y ago
  [deleted]
- jusben1369 7y ago
  Yep. They're locking in their upside to offset for the risk they see in putting in $5 million. 3x preferred is either a weak founder with a good company or more likely an ok founder desperate for funding and therefore pretty high risk for the investor.
- bdcravens 7y ago
  Yes.
- aetherson 7y ago
  In my opinion: Liquidation preference of 1x (or lower) is just sensible alignment of investor and founder incentives. The investor wants to make sure that if they buy 20% of the company for $5M, the founders aren't now incented to take advantage of them (in an extreme example: the day after the fundraising, liquidating the company for its assets, taking home $4M themselves and handing the investor back $1M. In a less extreme example, selling the company (in toto) for $10M a year or two later). Liquidation preference of higher than 1x is a whole different thing. It's, at its most benign, something kind of like a financial instrument a little more like debt than stock, trading a more-guaranteed return for a lower price, or at its most pernicious, basically an attempt to create false impressions of a company's value. If you sell stock with a x3 liquidation preference, that is deeply different, and conveys considerably less investor confidence, than selling the same stock at the same price with x1 liquidation preference, but the press releases get to not mention the preference.
  - jammygit 7y ago
    It may be sensible for the founders and investors, but is it sensible for the employees? Many startup employees are paid to a significant extent in stock and do not understand the situation they end up in. They are also powerless and just have to trust that the founders and investors will treat them well. Rationally, this leads to many of the best people ignoring the startup world
    - KallDrexx 7y ago
      VCs really don't care about "sweat equity" or "discounted salary equity". They believe that if you don't bring actual cash to the table then you aren't risking as much as them (even though they are only putting their clients money, not their personal money in most cases). That's one reason I didn't have trouble bailing on a startup I helped start. We took in $1.5mm, did some things poorly (such is life but learned good lessons from them) and even with a path forward we would have still required some more investment (since we weren't profitable). Therefore I knew what the current liquidation preference was, I computed what another round's liquidation preference would add, and it became clear we'd have to sell at $30-50m just for me to start getting money. The likelihood of that happening was small, and the feeling of being un-incentivized from selling at a respectable $20m made me realize the whole game was stupid and rigged. Now I work at a bank making almost 3x of what I made in hard cash (plus better benefits which equals hardware) and that extra money is giving me much better returns in my retirement and stock accounts, and a better quality of life (and less stress).
      - kevstev 7y ago
        I was the third employee at a startup. I was young and stupid and thought "20,000 shares" was a lot. I worked my ass off, it was immensely stressful, but we built and launched a product. I later found out it wasn't much of a stake at all- .1% and that's even before any dilution shenanigans and all that. We took a paycut part of the way through, had our 401k contributions slashed and such. A company in the space (but doing something different) called and made me an offer for twice what I was making. I was the lead developer by that point, had my hands in every significant piece of code, understood how everything fit together and such, and was appalled when I found out that I had such a small piece of the total pie. I demanded more, like 20x more, and they made it sound like I was asking to sleep with their wives. Then they absolutely howled that I was screwing them over by leaving right at launch- they asked me to stay for 3 months, which I said sure- if you match my new salary plus a little more as a retention bonus and to make up for some of the paycut, and again they howled at how could I do this to them... It was a painful lesson, but I learned something very important- Do not work like you are an owner if you are just an employee! I still to this day (this was 10 years ago now) feel very taken advantage of. I was working tons of late nights and weekends, was a super fanboy of the company, at one point I was going to buy us a company logo made out of Legos to hang on our wall, and now I just cringe at the thought. There are so many ways to lose in the startup game, just so many, its really not worth playing anymore IMHO unless you are a founder or very early stage employee with material access to the financials and such.
- deleted 7y ago
  [deleted]
jld 7y ago
Say a company sells 10% of itself to an investor for $10M, with a 2x preference. If the company sells for $100M, the investor gets $20M off the top. My question: Does the investor still own 10% of the shares, and will they recoup $8M of the remaining $80M? Is their $10M investment now worth $20M or $28M?
- ZiiS 7y ago
  $20M
- x0x0 7y ago
  That's called participation and it's negotiated as part of the raise. Non-participating: at liquidation, an investor chooses. They may either be paid back their investment (or more, if they have a multiple), OR they may choose to convert to common and get that percentage. They will, obviously, choose whichever pays them more =P Participating is then also obvious: investors get their money (or negotiated multiple) out, and then get their ownership percentage of the remainder. One thing that happens is companies very eager to raise monster rounds agree to shitty terms on all of the above. It's a lever founders and investors can manipulate to raise bigger rounds. see eg https://medium.com/@CharlesYu/the-ultimate-guide-to-liquidation-preferences-478dda9f9332 https://medium.com/@CharlesYu/the-ultimate-guide-to-liquidat... So your answer: $28m. Because if you agreed to 2x preferences, you're raising on shit terms and the investor probably got participation as well. Generally if you raise on good terms, you can get a 1x non-participating. But it's good to know the details.
- rmckayfleming 7y ago
  That's where the difference between participating and non-participating preferences come in. Participating meaning that they also participate in the remaining surplus (so on your example $28M). Non-participating means they choose whichever is better (in your example they wouldn't since $20M is better than 10% of $100M, but if the company sold for $300M they'd choose $30M instead of the $20M).
  - cnst 7y ago
    Shitz, and here I go thinking I knew everything about these sorts of things by attending a 5-day lunch-time course at Capital Factory on Founders Academy Essentials… So much for those cap tables!
cmancini 7y ago
Yeah I hear the terms 'liquidation preference' much more often than 'preference overhang'.
wtvanhest 7y ago
Founders are protected through carveouts that they can negotiate as part of the acquisition.
beambot 7y ago
Even more insidious: Participating Preferred, which is effectively double-dipping.
- yitchelle 7y ago
  For those not so deep in the world of startup, can you give a layman's explanation of what Participating Preferred is?
  - fludlight 7y ago
    Check out Venture Deals by Feld & Mendelson. It explains in layman's terms most anything you'll encounter during fundraising.
  - tptacek 7y ago
    As I understand it, from memory: I invest $100 for 20% of your venture. You sell for $200. Standard preference: I get $100, not $40, as my % would suggest, because I get at least every dollar I invested back. 2x preference: I get all $200, because I'm promised at least 2x my investment back. Participating preferred: I get $120 (I think?) --- I first get my invested dollars back, and then I still get my % of the venture.
    - arohner 7y ago
      To expand on your example: I invest $100 for 20% of your venture, implicitly valuing the company at $500 . You sell for $200. - Standard preference: I get $100 or 20% of the company ($40) - 2x preference: I get $200 or 20% ($40) - Participating preferred: I get $100 and 20% of the company ($140) IMO, 1x preference, non-preferred is entirely fair. In the event the company sells for lower than the valuation, the investors get their money back first. The vulnerability it protects against is that I found a company for $0, you invest $100 for 20%, then I immediately turn around and sell for $101. You get $20.25 and I get $79.75. Participating preferred and >1x preference are unconscionable.
      - tptacek 7y ago
paulddraper 7y ago
My tl;dr: There is preferred stock (full price; i.e. investors) and common stock (incentive plans; i.e. founders/employees). A liquidation employs one of two methods to distribute payment, depending on which is better for preferred shareholders: * Method 1. Preferred stock is converted into common stock (usually 1:1). All common stock receives payment. * Method 2. Preferred stock first receives payment according to liquidation preference which a multiple of the initial purchase value. Then participating preferred stock is converted into common stock (usually 1:1). Finally, all common stock receives the remainder of payment, if any. During preference, carveouts may protect certainly common shareholders. In good exits, method 1 is used. In bad or mediocre exits method 2 is used. --- Liquidation preference and participation are not required, but are tools to give founders more money per investor share. Nowadays, you should be able to get a solid valuation for 1x liquidation preference, non-participating, no carveouts. IMO this is a sensible compromise; if you can't even keep the initial investment value, you really haven't done well anyway.
tyrust 7y ago
It always baffles me when the top comment isn't discussing the article, but provides a response to the headline as if the article doesn't even exist.
- sam1r 7y ago
  Good point. I am not going to read this article anymore.
  - nighthawk648 7y ago
    :c but please!
- arkades 7y ago
  Better that than “random personal anecdote only loosely related to the title.” Those are too common.
- mhluongo 7y ago
  The clickbait title was what got me to this page, so why not? :)
- john-radio 7y ago
  You mean the linked article isn't just a 750-word essay version of "Huh?!?!"
- LudwigNagasena 7y ago
  It saves a click for many people who are tired of clickbait.
- dgzl 7y ago
  What's baffling about it? If someone were to only read the title and not the article and came to the comments section, a summary about the title would be desired. What you're probably baffled about is why do people only read the title and not the article.
  - 7y ago
tomrod 7y ago
I think I am misunderstanding. Is liquidation rate basically interest?
- teej 7y ago
  Interest rate is something that gets regularly paid out on an investment. Liquidation preference is something that typically pays out once when an illiquid investment (private company stock) becomes liquid (IPO or sells). They both share aspects in that you are investing money up front but they have different rules to how you get a return on that investment.
icedchai 7y ago
There are often dividends attached to preferred shares. This is basically interest, and may or may not accrue, and has to be paid out eventually. That's even more money off the top.

by cj 7y ago

ethanjinsen 7y ago

So in your example, the investors are basically getting a 300% return if the company sells for 15M or more?

deleted 7y ago
[deleted]
jusben1369 7y ago
Yep. They're locking in their upside to offset for the risk they see in putting in $5 million. 3x preferred is either a weak founder with a good company or more likely an ok founder desperate for funding and therefore pretty high risk for the investor.
bdcravens 7y ago
Yes.
aetherson 7y ago
In my opinion: Liquidation preference of 1x (or lower) is just sensible alignment of investor and founder incentives. The investor wants to make sure that if they buy 20% of the company for $5M, the founders aren't now incented to take advantage of them (in an extreme example: the day after the fundraising, liquidating the company for its assets, taking home $4M themselves and handing the investor back $1M. In a less extreme example, selling the company (in toto) for $10M a year or two later). Liquidation preference of higher than 1x is a whole different thing. It's, at its most benign, something kind of like a financial instrument a little more like debt than stock, trading a more-guaranteed return for a lower price, or at its most pernicious, basically an attempt to create false impressions of a company's value. If you sell stock with a x3 liquidation preference, that is deeply different, and conveys considerably less investor confidence, than selling the same stock at the same price with x1 liquidation preference, but the press releases get to not mention the preference.
- jammygit 7y ago
  It may be sensible for the founders and investors, but is it sensible for the employees? Many startup employees are paid to a significant extent in stock and do not understand the situation they end up in. They are also powerless and just have to trust that the founders and investors will treat them well. Rationally, this leads to many of the best people ignoring the startup world
  - KallDrexx 7y ago
    VCs really don't care about "sweat equity" or "discounted salary equity". They believe that if you don't bring actual cash to the table then you aren't risking as much as them (even though they are only putting their clients money, not their personal money in most cases). That's one reason I didn't have trouble bailing on a startup I helped start. We took in $1.5mm, did some things poorly (such is life but learned good lessons from them) and even with a path forward we would have still required some more investment (since we weren't profitable). Therefore I knew what the current liquidation preference was, I computed what another round's liquidation preference would add, and it became clear we'd have to sell at $30-50m just for me to start getting money. The likelihood of that happening was small, and the feeling of being un-incentivized from selling at a respectable $20m made me realize the whole game was stupid and rigged. Now I work at a bank making almost 3x of what I made in hard cash (plus better benefits which equals hardware) and that extra money is giving me much better returns in my retirement and stock accounts, and a better quality of life (and less stress).
    - kevstev 7y ago
      I was the third employee at a startup. I was young and stupid and thought "20,000 shares" was a lot. I worked my ass off, it was immensely stressful, but we built and launched a product. I later found out it wasn't much of a stake at all- .1% and that's even before any dilution shenanigans and all that. We took a paycut part of the way through, had our 401k contributions slashed and such. A company in the space (but doing something different) called and made me an offer for twice what I was making. I was the lead developer by that point, had my hands in every significant piece of code, understood how everything fit together and such, and was appalled when I found out that I had such a small piece of the total pie. I demanded more, like 20x more, and they made it sound like I was asking to sleep with their wives. Then they absolutely howled that I was screwing them over by leaving right at launch- they asked me to stay for 3 months, which I said sure- if you match my new salary plus a little more as a retention bonus and to make up for some of the paycut, and again they howled at how could I do this to them... It was a painful lesson, but I learned something very important- Do not work like you are an owner if you are just an employee! I still to this day (this was 10 years ago now) feel very taken advantage of. I was working tons of late nights and weekends, was a super fanboy of the company, at one point I was going to buy us a company logo made out of Legos to hang on our wall, and now I just cringe at the thought. There are so many ways to lose in the startup game, just so many, its really not worth playing anymore IMHO unless you are a founder or very early stage employee with material access to the financials and such.
deleted 7y ago
[deleted]

jld 7y ago

Say a company sells 10% of itself to an investor for $10M, with a 2x preference. If the company sells for $100M, the investor gets $20M off the top. My question: Does the investor still own 10% of the shares, and will they recoup $8M of the remaining $80M? Is their $10M investment now worth $20M or $28M?

ZiiS 7y ago
$20M
x0x0 7y ago
That's called participation and it's negotiated as part of the raise. Non-participating: at liquidation, an investor chooses. They may either be paid back their investment (or more, if they have a multiple), OR they may choose to convert to common and get that percentage. They will, obviously, choose whichever pays them more =P Participating is then also obvious: investors get their money (or negotiated multiple) out, and then get their ownership percentage of the remainder. One thing that happens is companies very eager to raise monster rounds agree to shitty terms on all of the above. It's a lever founders and investors can manipulate to raise bigger rounds. see eg https://medium.com/@CharlesYu/the-ultimate-guide-to-liquidation-preferences-478dda9f9332 https://medium.com/@CharlesYu/the-ultimate-guide-to-liquidat... So your answer: $28m. Because if you agreed to 2x preferences, you're raising on shit terms and the investor probably got participation as well. Generally if you raise on good terms, you can get a 1x non-participating. But it's good to know the details.
rmckayfleming 7y ago
That's where the difference between participating and non-participating preferences come in. Participating meaning that they also participate in the remaining surplus (so on your example $28M). Non-participating means they choose whichever is better (in your example they wouldn't since $20M is better than 10% of $100M, but if the company sold for $300M they'd choose $30M instead of the $20M).
- cnst 7y ago
  Shitz, and here I go thinking I knew everything about these sorts of things by attending a 5-day lunch-time course at Capital Factory on Founders Academy Essentials… So much for those cap tables!

cmancini 7y ago

Yeah I hear the terms 'liquidation preference' much more often than 'preference overhang'.

wtvanhest 7y ago

Founders are protected through carveouts that they can negotiate as part of the acquisition.

beambot 7y ago

Even more insidious: Participating Preferred, which is effectively double-dipping.

yitchelle 7y ago
For those not so deep in the world of startup, can you give a layman's explanation of what Participating Preferred is?
- fludlight 7y ago
  Check out Venture Deals by Feld & Mendelson. It explains in layman's terms most anything you'll encounter during fundraising.
- tptacek 7y ago
  As I understand it, from memory: I invest $100 for 20% of your venture. You sell for $200. Standard preference: I get $100, not $40, as my % would suggest, because I get at least every dollar I invested back. 2x preference: I get all $200, because I'm promised at least 2x my investment back. Participating preferred: I get $120 (I think?) --- I first get my invested dollars back, and then I still get my % of the venture.
  - arohner 7y ago
    To expand on your example: I invest $100 for 20% of your venture, implicitly valuing the company at $500 . You sell for $200. - Standard preference: I get $100 or 20% of the company ($40) - 2x preference: I get $200 or 20% ($40) - Participating preferred: I get $100 and 20% of the company ($140) IMO, 1x preference, non-preferred is entirely fair. In the event the company sells for lower than the valuation, the investors get their money back first. The vulnerability it protects against is that I found a company for $0, you invest $100 for 20%, then I immediately turn around and sell for $101. You get $20.25 and I get $79.75. Participating preferred and >1x preference are unconscionable.
    - tptacek 7y ago

paulddraper 7y ago

My tl;dr: There is preferred stock (full price; i.e. investors) and common stock (incentive plans; i.e. founders/employees). A liquidation employs one of two methods to distribute payment, depending on which is better for preferred shareholders: * Method 1. Preferred stock is converted into common stock (usually 1:1). All common stock receives payment. * Method 2. Preferred stock first receives payment according to liquidation preference which a multiple of the initial purchase value. Then participating preferred stock is converted into common stock (usually 1:1). Finally, all common stock receives the remainder of payment, if any. During preference, carveouts may protect certainly common shareholders. In good exits, method 1 is used. In bad or mediocre exits method 2 is used. --- Liquidation preference and participation are not required, but are tools to give founders more money per investor share. Nowadays, you should be able to get a solid valuation for 1x liquidation preference, non-participating, no carveouts. IMO this is a sensible compromise; if you can't even keep the initial investment value, you really haven't done well anyway.

tyrust 7y ago

It always baffles me when the top comment isn't discussing the article, but provides a response to the headline as if the article doesn't even exist.

sam1r 7y ago
Good point. I am not going to read this article anymore.
- nighthawk648 7y ago
  :c but please!
arkades 7y ago
Better that than “random personal anecdote only loosely related to the title.” Those are too common.
mhluongo 7y ago
The clickbait title was what got me to this page, so why not? :)
john-radio 7y ago
You mean the linked article isn't just a 750-word essay version of "Huh?!?!"
LudwigNagasena 7y ago
It saves a click for many people who are tired of clickbait.
dgzl 7y ago
What's baffling about it? If someone were to only read the title and not the article and came to the comments section, a summary about the title would be desired. What you're probably baffled about is why do people only read the title and not the article.
- 7y ago

tomrod 7y ago

I think I am misunderstanding. Is liquidation rate basically interest?

teej 7y ago
Interest rate is something that gets regularly paid out on an investment. Liquidation preference is something that typically pays out once when an illiquid investment (private company stock) becomes liquid (IPO or sells). They both share aspects in that you are investing money up front but they have different rules to how you get a return on that investment.

icedchai 7y ago

There are often dividends attached to preferred shares. This is basically interest, and may or may not accrue, and has to be paid out eventually. That's even more money off the top.