If you are an entrepreneur who is raising money and do not know what a liquidation preference is, allow Ensmarten Saturday to enlighten you.

You are not alone. One of my many surprises as a venture capitalist was the number of entrepreneurs that simply do not understand many of the terms on a term sheet. For example, a couple of years ago, one of the very best entrepreneurs that I have ever met pulled me aside and asked to go to coffee. At the coffee, he revealed that he did not understand what a liquidation preference was and asked if I would explain it.

This blog is premised on that same basic idea. It is not exhaustive, and there are many different iterations of liquidation preferences. But it is a key term for both the investor and the entrepreneur to understand.

First, the idea of the liquidation preference is that the investor in a preferred round will receive this “preference” by being protected with liquidation first in certain circumstances. There are three basic types of liquidity preference:

• Participating: the preference is paid out first, and then the rest of the liquidation is paid out in percentage;
• Participating with a cap: the investor makes a choice to take the preference which usually is three times the initial investment OR participate as if she were a common shareholder;
• Non-participating: the investor chooses the one-time preference OR to participate as if she were a common shareholder.

To illustrate, let’s walk through a simple venture capital transaction. In this transaction, a company raises $1 million dollars from an investor, call her Investor X, at a $5 million post-money valuation. Thus, the investor owns 20% of the company.

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1. Participating

In the participating instance, we will assume that the preference is the standard 1:1 preference used by most venture capitals and angel investors in the Midwest. This preference means that the first $1 million is paid to the investor and whatever is left is split by the investor and the company’s other shareholders.

• Scenario 1: The company sells for $100 million dollars. [Congratulations, everyone is happy!] In this instance, the investor receives the first $1 million and the next $99 million is split 80% ($79.2m) to the founders (or other shareholders) and 20% to Investor X ($19.8m). So Investor X receives $20.8m on this transaction.
• Scenario 2: The company sells for $10 million dollars. In this instance, the investor receives the first $1 million and the next $9 million is split. So, the founders receive $7.2 million or 80% of the residual. Investor X receives $1.8m of the residual for a total of $2.8 million.
• Scenario 3: The company sells for $2 million dollars (which is lower than its funded valuation). Here the investor gets the first $1 million and splits the residual $1 million with the founders. Thus, the investor still makes money on the transaction at $1.2 million in total dollars returned. This is not a great return for the investor – but the original corpus of the investment is protected in this type of scenario.
• Scenario 4: The company sells for $100k. In this instance, the investor gets $100k and the founders get $0. This is bad for everyone. But the difference between Scenario 3 and Scenario 4 illustrates a time when founders and investors interests can diverge on economic outcomes.

Most investors prefer participating preferred because this type of stock so clearly provides economic protection while retaining the upside. However, many investors also recognize that this contract term provides some strange economic incentives at times and potentially tips the scales of economic advantage in the transaction in favor of the investor. Investors recognize that the entrepreneur may have options, so not all investors will push for this type of instrument initially.

   2.  Participating with a cap

There is a cap In the second type of liquidation preference. We are going to give the example as if the cap was 3x. That means that the investor makes a decision to either convert to common OR take a return based on the cap. So, using the same four behaviors as we listed above, we will illustrate changes or differences in how this term produces returns.

• Scenario 1: In this scenario, the company sells for $100m. The investor would elect to take the common return of 20% rather than the $3m capped return. Thus, the investor converts to common and receives 20% of the $100m or $20m. The founders or other shareholders get the other 80% or $80m.
• Scenario 2: This is a tricky scenario for some to understand. Basically, the investor COULD convert to common and receive 20% of $10m ($2m). However, their economic incentive is to actually use the cap to get $3m. The liquidity preference and cap is specifically built to juice returns in scenarios like this. So, instead of a 2x return, the investors get a 3x return. The founders and other shareholders get the residual – or $7m.
• Scenario 3: This scenario is the one where entrepreneurs generally get nervous. The company sells for $2m. The investors get all $2m, and the founders and entrepreneurs get $0. This is because the cap is invoked and the liquidity preference covers the entire sale amount.
• Scenario 4: In this scenario, the company liquidates and has $0. Everyone gets $0. In certain instances, there are other terms in the agreement that may actually create liability on founders or shareholders – but not in the particular scenario that we are discussing.

  3.  Non-participating

Our final example is non-participating preferred. This liquidation preference type means that the investor elects to either receive the liquidation preference or to convert (or essentially convert). Functionally, this means that if the dollar amount that she would receive is greater by simply owning common stock, then the shareholder will convert and receive a common share of the rewards. Conversely, as in the capped case, if the company is valued lower than the original purchase price, the investor will choose to protect the original corpus or at least as much of it as is still available.

• Scenario 1: As in the earlier examples, selling a company for $100m is usually a good result for everyone. This case is no different. The investors can elect to take $1m or convert and receive $20m. As rational investors, they will convert. Founders or other shareholders will receive $80m
• Scenario 2: In this case, where the company sells for $10m, the conversion generates a 2x return for the founder and the non-conversion returns the investors’ money. So, the investor will convert – leaving 80% for the founders and other shareholders. This means $8m goes to the founders. This scenario represents the best outcome for this type of exit. In the participating scenario, the founders only receive $7.2 and in our capped scenario $7. So, non-participating is probably the best scenario for founders in this middle-level outcome.
• Scenario 3: When the company sells at a loss compared to its funded valuation, any liquidation preference will be set up to mitigate the investor’s loss in that event. In the case of a $2m sale, the investor gets all of her money back. The founders get $1m.
• Scenario 4: When a company dissolves with no assets, all of the players lose.

The reason that liquidation preference is so important to an entrepreneur is that they can unwittingly give away a significant economic asset in small and medium scale success if they do not clearly understand the terms. Liquidation preferences as I am explaining in these scenarios are not about the home run outcome. These preferences are really about the small success.

The small success is not the preferred outcome for anyone, but receiving between $7m – $8m for an entrepreneur or a team of two or three is still usually a very satisfactory result. Not so for an investor. The extra juice matters a lot on the long-term return of the fund. The difference between a net 0 and a complete loss is significant – as is a few hundred thousand dollars to a small success. This difference can take the result from acceptable to good.  The liquidation preference both prevents downside loss while also juicing a small return into something a little sweeter. This matters to an investor.

Thus, the type of liquidation preference on a term sheet or in an arrangement can have a significant effect on the way the deal turns out for the investor. Because many entrepreneurs do not fully understand liquidation terms, investors will sometimes take advantage of this naivete or ignorance. For example, I have seen a 3x participating be described by an entrepreneur as a 3x cap.  As I’ve explained in this article – they are not the same.