This is the first in a series of guest articles written by our Senior Mentor, Rupam Biswas on what founders should be mindful of when analyzing a term sheet. Rupam has been an institutional investor and Angel investor as well as a startup founder so is well-placed to help founders ensure they don’t make mistakes which could cost them dearly.
Part 1: Things to look out for in Term Sheets: Liquidation Preference
What is a Term Sheet?
Term Sheet is a document that outlines the key terms and conditions of a potential investment deal between a startup and an investor. Term Sheets set the valuation and key rights of the investor, founders and the company. It is not legally binding, but it serves as a basis for negotiations and due diligence. Term sheets can vary in length and complexity, but there are some common terms that founders should pay close attention to. In this series of articles, we will look at some of the key terms closely and break it down for early stage founders as they look to raise funds.
In this article, we will look at Liquidation Preference.
Liquidation Preference is a clause that determines how the proceeds from an exit, sale or liquidation of the company are distributed among the shareholders.
What is Liquidation Preference?
Investors usually hold preference shares instead of common shares in a startup. Preference shares are practically similar to common shares but come with certain preferential rights. Holders may have the right to get dividends or be bought out in preference over (i.e. before) holders of common shares.
Preference means that these investors get paid first during an exit event which is also referred to as liquidation event. This right to get paid first is known as Liquidation Preference. The clause also elaborates on the amount and the distribution waterfall.
Why do investors want Liquidation Preference?
Investors want liquidation preference because it protects them in downside scenarios where the company is not meeting expectations. It ensures that they get a minimum return on their investment, usually the original investment or at times, more than the investment. It gives them a higher priority than common shareholders (usually the founders and employees) in getting their money back whenever a liquidation event, such as a sale / acquisition, merger, or bankruptcy occurs.
How does Liquidation Preference actually work?
There are different types of liquidation preferences. The 2 most common types are:
There is a third uncommon type of liquidation preference called Capped Liquidation Preference where it is Participating Liquidation Preference but with a cap or upper There is a third uncommon type of liquidation preference called Capped Liquidation Preference where it is Participating Liquidation Preference but with a cap or upper limit on the total proceeds that the investor can get.
What should founders ideally agree to?
Founders should always aim for 1x liquidation preference on a non-participating basis.
Participating liquidation preference, i.e. double dip by investor, should be avoided at all costs. It is also recommended not to ever agree to more than 1x liquidation preference, i.e. more than the original investment amount. A combination of these can wipe out the majority of potential payouts for employees and founders even in good performance scenarios.
For example, say
If the company is sold soon after for $18 million, the proceeds will be distributed in this order:
Investors receive $12.64m or ~70% of the total proceeds and earn a 2.5x multiple while Founders and Employees receive $5.36m or ~30% of the proceeds despite owning 67% of the company.
In contrast, if the investment was made at 1x Non-Participating Liquidation Preference, Founders and Employees would have made 67% of the proceeds i.e. $12.06m.
Therefore, when startups face tough negotiations on Liquidation Preference, our advice is always to find ways of avoiding Participating Liquidation Preference. If need be and in desperate times, founders may agree at most to a 1.5x Non-participating Liquidation Preference. As a last resort, it may be prudent to even lower the valuation than to agree to a Participating Liquidation Preference.
Rupam Biswas is General Manager at PropertyGuru Group and an Advisor and Senior Mentor at Accelerating Asia Ventures
Accelerating Asia invests in startups with scalable technology solutions and revenue generating business models that combine purpose with profit.
In making an investment decision, investors must rely on their own examination of startups and the terms of the investment including the merits and risks involved. Prospective investors should not construe this content as legal, tax, investment, financial or accounting advice.
