Valuation vs. Liquidation Preference

A lot of good articles have been written on why liquidation preference exists, what there features are, and how the terminology is used. Nevertheless, negotiations can get tough around Valuation vs. Liquidation Preference. I still see a lot of founding teams being too heavily focussed on valuation. So I felt it might be useful to add one more article on that question using a simple example to help founders and investors to find some common ground when discussing deal terms.

Participation vs. Non-Participating Liquidation Preference

As a starting point lets look at the most relevant form of liquidation preferences. For those of you not being familiar with theses terms, here is what they mean in a nutshell. For this small article I will not go into the details. Instead I will focus on the most relevant forms neglecting things like multiple liquidation preferences, cappped versions and liqudiation preferences with interest:

In ist most common form Participating Liquidation Preferences (e.g. 1,0x) mean that the investor will get paid his or her initial investment and in addition will share in any remaining proceeds in proportion to his equity share in the company.

On the other hand, a Non-Participating Liquidation Preference (e.g. 1,0x) effectively leaves the investor with one of two options. The investor can choose to either (1) receive back his or her investment amount or (2) share in the proceeds in proportion to his equity ownership. Consequently, as a rationally investors, one would choose whichever option provides the better outcome.

How to compensate valuation with liquidation preferences and vice versa

To find common ground while negotiating deal terms it always helps to do the math. In other words, quantify the value of your options. Here is a simple example of liquidation model investment banking:

  • A 100% founder owned startup is going to raise a 1Mio. EUR seed round
  • There are two interested investors A and B placing their offers as follows:

Investor A offers 5 Mio. EUR pre-money valuation and a 1,0x Participating liquidation preference

Investor B offers 3,8 Mio EUR pre-money valuation and a 1,0x Non-Participating liquidation preference

  • Exit Proceeds (lets be realistic) are expected at 20 Mio. EUR

Founder focus is on valuation and so he or she decides to go for Investor A.
Having closed the round with Investor A the captable and the exit proceeds distribution looks as follows:


Lets compare the scenario above with Investor B`s offer. While offering a significantly lower valuation (3,8 Mio. EUR vs. 5 Mio. EUR) he is willing to accept a 1,0 Non-Participating Liquidation Preference. Accepting the offer from Investor B would leave the founder with the following captable and exit proceeds distribution:


As you can see there is a trade-off between valuation and liquidation preference. This is defining the room for negotiation dealterms. While Investor B offers a significantly lower valuation the exit proceeds distribution is the same in both scenarios.

Conclusion

Here is what should take away from this simplistic example:

  • Valuation alone is irrelevant, always negotiate the full package
  • Do the math and always value the full package
  • Calculate the scenarios and play with the parameters to quantify your options in order to make informed decisions on liquidation recovery rates
  • Knowing the room for negotation makes it easier to find agreement

Of course, there is a lot more to be considered when it comes to liquidation preferences. The actual outcome depends on the concrete parameters (downside protection character, round size, exit proceeds expectations, etc.). However, these small examples show that founders (and investors) should always look at the combination of valuation and liquidation preference.

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