Before you join or start a startup, you should understand this concept.
Let’s talk about share liquidation preference.
A clause in a term sheet that VCs use to protect their investment is called liquidation preference. The clause specifies that, in the event of an exit, investors must be paid a multiple of their investment amount before any other shareholders are paid.
This is intended to protect investors in certain situations. However, it may be detrimental to other common shareholders if the company fails to generate enough money in an exit to clear the liquidation hurdle.
A 1x multiple liquidation preference is the accepted norm.
If the investor decides to exit, they can exercise their liquidation preference if it is greater than the proceeds based on ownership percentage.
However, a startup with little to no runway may find themselves with no choice but to accept an aggressive term sheet from an investor with a 5x liquidation preference.
Consider the following two examples:
An investor invests $5 million in startup A in exchange for a 20% equity stake at 1x liquidation preference.
- $5 million exit = $5 million to the investor, $0 million to others
- $25 million exit = $5 million to the investor and $20 million to others
- $30 million exit = $6 million to the investor, $24 million to others
Investor invests $5 million in startup B for a 20% stake at 5x liquidation preference – $5 million exit = $5 million to investor, $0 to others
- $25 million exit = $25 million to the investor, $0 to others
- $30 million exit = $25 million to the investor, $5 million to others
In the case of Startup B, unless the exit price is greater than $125 million, the investor will always execute their liquidation preference because it results in a higher outcome for the investor – 20% of exit vs $25 million.
Unfortunately, this means that founders and employees may receive little to no compensation for the company they’ve spent years building.