Understanding liquidation preferences

A startup's guide to protecting equity
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Today, we're diving into a topic that's crucial for any young entrepreneur dreaming of taking their startup to the next level: venture capital and the infamous "liquidation preferences." Yeah, it sounds a bit like jargon, but stick with me. Understanding this could be the difference between sailing off into the sunset with bags of cash or watching your hard work fizzle out with nothing to show for it. 💸


The Basics: Liquidation Preferences 101

When venture capitalists (VCs) invest in your company, they're not just giving you money out of the kindness of their hearts. They're buying a piece of your business and want to protect that investment. That's where "liquidation preferences" come in. It's a clause in the investment contract that determines who gets paid first (and how much) if your company is sold or goes belly-up.

There are two main flavours to know about:

Non-participating liquidation preferences:

This is like the basic vanilla of VC clauses. This means investors get their initial investment back first when the company is sold. After they've been paid, any remaining money is distributed to the other shareholders (like you, the founder).

Participating liquidation preferences:

This one's a bit more like vanilla bean – it's got an extra kick. Not only do investors get their money back first, but they also get to "double dip" and share the remaining proceeds. If their terms include "2x" or "3x," they could take home two or three times their initial investment before anyone else sees a dime.

Examples that hit home

Let's break it down with some examples to see how these preferences play out in the wild:

Scenario 1: Your company sells for €5 million, and a VC has invested €3 million with a 1x non-participating preference. They might just take their €3 million off the top, leaving €2 million for you and any other shareholders.

Scenario 2: The stakes are higher, and your company sells for €20 million. With that non-participating clause, the VC could opt to convert their preference to equity, essentially ignoring the preference to share the full pot, giving both of you €10 million each.

Double Dip Disaster: If the VC has a 2x participating preference and your company sells for €5 million, they could sweep the entire amount, leaving you with zilch. But, if you hit a jackpot and sell for €50 million, they'd rake in €28 million, and you'd get €22 million—not too shabby, but still a significant chunk gone before you see a penny.

The moral of the story

Liquidation preferences are like a circus tightrope. They're all about balance and ensuring you don't fall off into the safety net with nothing but your circus costume. Here's how to not be the clown:



👉  Know your terms: Understand the different types of liquidation preferences and how they affect you.


👉 Read carefully: That term sheet isn't just another app terms and conditions agreement. Read it, understand it, and don't rush.


👉 Negotiate: Everything in venture capital is negotiable. Aim for terms that are fair and won't leave you out in the cold if things go south.


👉 Get expert advice: This isn't the time to 'wing it.' Talk to lawyers, mentors, and others who have walked this path.

Securing funding is like the first big drop on a rollercoaster. It's thrilling, but what comes next is equally important. Don't let the excitement cloud your judgment. The decisions you make now can and will shape the future of your startup.



So, take a breath, do your homework, and make sure you're ready for the ride!

Written by: Leopold van Oosten, on April 4, 2024