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Liquidation Preference & Exit Waterfall [+ Free Template]

Founders often get confused when it comes to who gets what at exit. Indeed, exit proceeds aren’t simply a function of how much stock you own as a founder or investor. Instead, liquidation preference clauses can seriously impact an exit waterfall, and reduce your payout as a founder.

What actually is a liquidation preference? How does it impact founders’ proceeds at exit? 

In this article we’ll demystify one of the most misunderstood concepts for founders: liquidation preference clauses. 

We’ve also included examples and a free template below to make it easier for you to model different scenarios. We will cover:

Valuation Is Only Part Of The Story

When asking how much one should get at exit, we’re naturally thinking about the company’s valuation and the relative percentage of ownership one owns.

For example, if an investor invests $5 million in a startup at a $20 million pre-money valuation, he gets 20% ownership. Assuming no other previous or future investments, if the company is then sold a few years later for $100 million, the investor gets $20 million, right? 

The above is only true if all investors are treated equal, meaning if they have purchased the same security

Indeed, the problem arises when preferred investors come into play. Preferred investors are a type of investor who purchases and owns preferred shares (or “prefs”). For startups, most investors who aren’t the founders themselves (VC funds, angel investors) typically are preferred investors. 

Unlike common shares (or “ordinary shares”), preferred shares come with specific terms that make them more valuable. One of these clauses is liquidation preference.

Liquidation Preference: What Is It?

Liquidation preference is a clause in a startup’s term sheet that defines the priority preferred stock investors have over common stock investors when exiting their participation.

There are 3 types of prefs:

  • Non-participating prefs: when the business is sold, preferred stockholders are entitled to a multiple of their initial investment as proceeds. The distribution happens before any distribution to common shareholders (thereby preferential treatment)
  • Participating prefs: at exit, preferred stockholders get the return of their initial investment first, plus a share of the proceeds left after all preferred stockholders have been paid, like any other common stockholder. Effectively, preferred investors are paid twice, as preferred investors (first payout) and common investors (second payment)
  • Capped participating prefs: at exit, preferred stockholders get the return of their investment, plus a capped share of the proceeds left to common stockholders. Capped participating preferred is therefore a compromise between the 2 methods discussed above

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Non-Participating Liquidation Preference

Non-participating is the simplest form of liquidation preference. It is also the most attractive for founders.

As explained earlier, pref investors at exit are returned a multiple of their initial investment. Therefore, their distribution is prior any other common stockholder’s exit proceeds.

Let’s use an example, assuming:

  • A startup with a $8 pre-money valuation
  • A pref investor that purchases $2 million prefs with a 2x liquidation multiple

The pref investor therefore owns 20% of the company, and the common stockholders the remaining 80%.

Finally, let’s assume the startup is sold at $20 million. At exit:

  • The pref investor gets $4 million (2x its original investment)
  • The common shareholders share the rest of the proceeds i.e. $16 million
InvestorOwnershipPayout
Preferred20%$4 million
Common80%$16 million
Assuming a 2x multiple

Here is how the payouts would look like if the prefs had a 3x multiple instead:

InvestorOwnershipPayout
Preferred20%$6 million
Common80%$14 million
Assuming a 3x multiple

Exit waterfall

Assuming a 2x multiple, here’s how the exit waterfall would look like depending on valuation at exit:

exit waterfall preferred liquidation non-participating clause
Exit waterfall assuming 2x non-participating liquidation preference

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Participating Liquidation Preference

Participating liquidation preference is more attractive to pref investors. Indeed, at exit, they get a multiple of their investment plus share the remaining proceeds with the common shareholders according to their ownership percentage.

Using our example above, and assuming a 2x multiple:

  • First, the pref investor would get $4m using the 2x multiple
  • The remaining $16m proceeds would then be shared amongst all investors: $3.2m for the pref investor and $12.6m for the common shareholders
InvestorOwnershipPayout
Preferred20%$7.2 million
Common80%$12.8 million
Assuming a 2x multiple

Therefore, participating liquidation preference is far more aggressive and can seriously reduce common shareholders’ interest and payouts. That’s why participating liquidation preferences are generally red flags for any startup.

Exit waterfall

Assuming a 1x multiple and a participating liquidation preference clause, this is how the exit waterfall would look like depending on valuation at exit:

Exit waterfall assuming 2x participating liquidation preference
Exit waterfall assuming 1x participating liquidation preference

Capped Participating Liquidation Preference

As explained above, capped participating is a form of liquidation preference clause that works very much as for participating. Yet, the only difference is that the payouts shared with common shareholders are capped at a certain amount.

So using the same example above, and assuming a 2x multiple:

  • First, the pref investor would get $4m
  • Secondly, the next $10m is shared amongst all investors: $2m for the pref investor and $8m for the common shareholders
  • Finally, the remaining $6m goes to the common shareholders
InvestorOwnershipPayout
Preferred20%$6 million
Common80%$14 million
Assuming a 2x multiple and a capped participating liquidation preference at $14 million

Exit waterfall

Assuming a 1x multiple and a capped participating liquidation preference clause at $14 million, this is how the exit waterfall would look like:

Exit waterfall assuming 1x capped participating liquidation preference
Exit waterfall assuming 1x capped participating liquidation preference at $14m

Expert-built templates for tech startups

  • Investor-friendly
  • Easy-to-use Excel & PPT templates
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Be Wary Of Dead Spots

Understanding how liquidation preference clauses impact cap tables and exit waterfalls is key. Indeed, investors behave differently based on their exit proceeds expectations.

For example, with non-participating and capped participating clauses, there are scenarios where investors returns don’t change despite valuation: we call these valuation ranges “dead spots”.

Let’s use below examples in each scenario: with non-participating and capped participating clauses.

Non-participating example

Following our non-participating example above, here’s how would look like our exit waterfall as well as the dead spot:

A dead spot for preferred shareholders

Whenever valuation is above $10 million, preferred investors get the same payout: $4 million.

This can be a serious problem, as pref investors won’t necessarily look for a higher valuation to sell the business. If the startup gets an offer for $10 million for example, pref investors would rather cash out immediately vs. waiting to get another offer 1 year down the line for a higher valuation.

Therefore, dead spots can create misalignment of interests between common and preferred shareholders. As a founder, you should be aware of these dead spots to make sure your decisions are aligned with everyone’s interests.

Capped participating example

Following our capped participating example above, here’s how would look like our exit waterfall as well as the dead spot:

A dead spot for preferred shareholders
A dead spot for preferred shareholders

In this scenario, the dead spot occurs whenever valuation is above $17 million. Indeed, beyond that, preferred investors returns are capped at $6.8 million.

Expert-built templates for tech startups

  • Investor-friendly
  • Easy-to-use Excel & PPT templates
  • CPA-developed financials
  • 30+ charts and metrics