Getting Paid First: Understanding Liquidation Preference in Startup Fundraising
Introduction
When raising funds for a startup, entrepreneurs may come across the term "liquidation preference." Liquidation preference is a term used to describe the order in which investors are paid back in the event of a company's liquidation or sale.
In this blog, we will explain what liquidation preference is, why it's important, and how it can impact a startup's fundraising efforts.
What is Liquidation Preference?
Liquidation preference refers to the order in which investors are paid back in the event of a company's liquidation or sale. It is a term used to describe the amount of money that investors receive before the remaining funds are distributed to the company's other stakeholders. Understanding what liquidation preference is and how it works is essential for any entrepreneur who is raising money for their startup.
There are two types of liquidation preference: participating and non-participating.
Participating liquidation preference means that investors receive their investment back first, plus any dividends or interest that may have accrued. After that, they are entitled to participate in the remaining proceeds on a pro rata basis with all other shareholders. This means that investors with participating liquidation preference receive a greater percentage of the proceeds from the liquidation or sale, even if they don't own as much equity as other shareholders.
Non-participating liquidation preference, on the other hand, means that investors receive their investment back first, plus any dividends or interest that may have accrued. After that, the remaining proceeds are distributed pro rata among all shareholders based on their ownership stake.
For example, let's say that a startup raises $10 million from investors with a participating liquidation preference of 2x. This means that if the startup is sold for $20 million, the investors would receive their original investment of $10 million, plus an additional $10 million (2 times their original investment). This would leave $10 million remaining, which would be distributed pro rata among all shareholders based on their ownership stake.
Why is Liquidation Preference Important?
Liquidation preference is important for both investors and entrepreneurs. For investors, it provides a level of protection in the event of a company's liquidation or sale. It ensures that they receive a predetermined amount of money before other stakeholders, which can be particularly important in situations where a company's value has declined since the investment was made.
For entrepreneurs, liquidation preference can impact their ability to raise funds. Investors may require a higher liquidation preference in exchange for their investment, which can reduce the amount of money available to the company's other stakeholders.
How does Liquidation Preference Impact Fundraising?
Liquidation preference can impact a startup's fundraising efforts in several ways. For example, if an investor requires a participating liquidation preference, it means that they will receive a predetermined multiple of their investment before any other stakeholders are paid. This can reduce the amount of money available to the company's other stakeholders, which can make it more difficult for the startup to raise funds in the future.
On the other hand, if an investor requires a non-participating liquidation preference, it means that they will receive either their investment or a predetermined multiple of their investment, whichever is greater. This can be less restrictive for entrepreneurs, as it ensures that investors are protected without reducing the amount of money available to other stakeholders.
Conclusion Liquidation preference is an important term for entrepreneurs to understand when raising funds for a startup. It describes the order in which investors are paid back in the event of a company's liquidation or sale.
There are two types of liquidation preference: participating and non-participating. Liquidation preference can impact a startup's fundraising efforts, as investors may require a higher liquidation preference in exchange for their investment, which can reduce the amount of money available to the company's other stakeholders.
By understanding liquidation preference, entrepreneurs can negotiate better terms with investors and make informed decisions about their fundraising strategies.