When it comes to equity, it’s important to know what you’re owed in the event of an exit or payout. The rules that govern these are called liquidation “rights and preferences.”
Get these wrong and it could mean a harsh wake-up call. Take it from entrepreneur and investor Michael Arrington: he raised $18 million for his first company Achex, sold it for $32 million, and earned nothing except a big lesson about venture capital liquidation preferences.
When a private company exits, who gets paid what (and when) is primarily dictated by the following rights and preferences:
- Original issue price
- Liquidation preference
- Liquidation multiplier
- Cumulative dividends
- Conversion ratio
- Participation
Rights and preferences are typically referred to as either “standard” or “non-standard.”
- Standard terms are more common and less dilutive to common stockholders when a company exits.
- Non-standard terms are less common and more dilutive to common stockholders when a company exits.
A particular company’s rights and preferences may include a mixture of standard and non-standard terms. We’ll cover both standard and non-standard terms for each of the various rights and preferences, and how they can affect stockholder payouts in the event of an exit.
Original issue price
The original issue price (OIP) is the price at which investors purchased preferred shares. This also dictates the investor’s “liquidation preference,” which, under standard terms, typically equals the preferred share’s OIP multiplied by the investor’s outstanding number of preferred shares.
When a company exits, preferred shares are typically required to be paid their liquidation preference before other equity holders. Investors may convert their preferred shares to common shares when they deem it to be more advantageous.
Liquidation preference
As mentioned earlier, a preferred shareholder’s liquidation preference is typically paid out first as a result of seniority rights. Seniority rights ascribed to share classes will determine which share classes get paid out first.
For example, let’s say a Series B company exits via acquisition. Here’s what might happen under standard and non-standard terms:
| Investors | Standard | Non-standard |
|---|---|---|
| Series B | Liquidation preferences are paid together | Paid out first |
| Series A | Liquidation preferences are paid together | Paid out second |
| Series Seed | Liquidation preferences are paid together | Paid out last |
When a company’s exit value amounts to less than the combined liquidation preferences, common holders receive no payout. Meanwhile, investors holding preferred shares with seniority rights have added protection against downside exit scenarios.
Liquidation multiplier
An example of non-standard terms is when preferred shareholders have a “liquidation multiplier.” These terms allow investors to receive a “multiple” of their liquidation preference before choosing to convert their preferred shares into common shares (when it’s more lucrative).
Assume an investor owns 1 million shares of Series A preferred with an OIP of $1.00. Under standard terms, their liquidation preference would be $1 million.
However, if the Series A preferred shares have a liquidation multiplier of 2x, their liquidation preference would be $2 million.
| Preferred shares at OIP of $1 | Results if company sells for $1 million | Results if company sells for $2 million |
|---|---|---|
| 1 million shares of preferred stock with 1x multiplier
1 million shares of common stock |
Preferred receive $1 million
Common stockholders receive nothing |
Preferred receive $1 million Common stockholders receive the other $1 million |
| 1 million shares of preferred stock with 2x multiplier
1 million shares of common stock |
Preferred receive $1 million
Common stockholders receive nothing |
Preferred receive $2 million Common stockholders receive nothing |
Liquidation multipliers give investors additional protection against a company’s downside exit scenarios, but as shown above, this comes at the expense of other equity holders.
Cumulative dividends
Dividends are a right associated with preferred stock. You can think of dividends like interest that accrues on debt. For preferred shares, dividends are either designated as cumulative or non-cumulative. Cumulative dividends are earned and accrue over time, whether or not it is declared by the board. Non-cumulative dividends accrue and are paid out at the discretion of the board. Typically, cumulative dividends accrue from the shares’ issue date up until the company’s exit. Any accrued dividends are added to the investor’s liquidation preference upon a company’s exit.
Need an example? Let’s again assume an investor purchases 1 million shares of Series A preferred stock with an OIP of $1.00. If these shares have a non-compounding cumulative dividend right of 5%, if the company were to exit in five years, the investor would be owed the liquidation preference of $1 million and $0.25 million of accrued dividends.
Cumulative dividends are non-standard terms. Similar to the liquidation multiplier, cumulative dividends provide additional protection to investors in downside scenarios—at the expense of common stockholders.
Conversion ratio
Investors may elect to convert their preferred shares into common shares when it’s more advantageous for them to do so. Here’s an example of why:
| Investor | $0.80 value of common share upon exit | $1.20 value of common share upon exit |
|---|---|---|
| Investor with OIP of $1 and 1 million preferred shares | The investor would rather maintain their liquidation preference and receive a payout of $1 million | The investor would rather convert their preferred shares into common shares and receive a payout of $1.2 million |
The above example represents the preferred stockholder’s payout assuming a standard conversion ratio of one-to-one. If the value of a common share at exit is higher than the liquidation preference (plus dividends accrued, if any) of your preferred shares, investors would convert their preferred shares into common stock.
Under non-standard terms, the conversion ratio could be something other than one-to-one. For example, let’s take the above scenario (i.e. investor with OIP of $1 and 1 million preferred shares) and assume the conversion ratio is three-to-one. In this scenario, investors would only convert their preferred shares into 3 million common shares if the value of one common share were $0.33 or more. In other words, the investor receives triple the amount of common shares upon exit so they would convert at a lower value of common.
A non-standard conversion ratio allows investors to convert into common shares at a lower price. As a result, investors have the opportunity to participate in more of the company’s upside potential. It also awards investors greater ownership in the Company in the event of an exit, as shown below.
| One-to-one conversion ratio | Common | Preferred | Total |
|---|---|---|---|
| Share count upon liquidation | 1,000,000 | 1,000,000 | 2,000,000 |
| Ownership percentage | 50% | 50% | 100% |
| Three-to-one conversion ratio | Common | Preferred | Total |
|---|---|---|---|
| Share count upon liquidation | 1,000,000 | 3,000,000 | 4,000,000 |
| Ownership percentage | 25% | 75% | 100% |
Participation
Participation is an economic benefit that allows preferred shareholders to receive additional proceeds on top of the liquidation preference without having to convert their preferred shares into common shares. In a liquidation scenario in which the proceeds are above the amount invested in the company, the preferred shareholders receive back their liquidation preference and then get to share in any remaining proceeds with the common stockholders pro-rata on an as-converted basis. Essentially, the preferred shareholders “double dip” in favorable exit scenarios.
In other words, if an investor commits $1 million, owns 15% of the company, and it subsequently sells for $2 million, they’d receive:
- Their initial investment of $1 million (liquidation preference)
- An additional $150,000 ($1 million x 15%)
When investors are allowed to “double dip” like this, it can leave founders and employees feeling shortchanged.
In the above example, we assumed full participation. There is also something referred to as capped participation. With capped participation rights, investors only participate in the “remaining proceeds” with common stockholders until they reach their cap, which is typically a multiple (e.g., 2x or 3x) of their liquidation preference.
Here are some examples, assuming 1 million preferred shares with an $1.00 OIP and 1 million common shares:
| Type | Payout if company sells for $2 million | Payout to preferred | Payout to Common |
|---|---|---|---|
| Non-participating preferred | (1) Preferred receive $1 million (2) Common stockholders receive the other $1 million |
$1 million | $1 million |
| Fully-participating preferred | (1) Preferred receive $1 million (2) Preferred and common stockholders split the remaining $1 million based on ownership percentage on an as-converted basis |
$1.5 million | $0.5 million |
| Participating preferred with a 2x participation cap | (1) Preferred receive $1 million (2) Preferred and common stockholders split the remaining $1 million based on their ownership percentage on an as-converted basis |
$1.5 million | $0.5 million |
| Type | Payout if company sells for $3 million | Payout to Preferred | Payout to Common |
|---|---|---|---|
| Non-participating preferred | (1) Preferred foregos liquidation preference (2) Common and preferred are paid out based on ownership percentage on an as-converted basis |
$1.5 million | $1.5 million |
| Fully-participating preferred | (1) Preferred receive $1 million (2) Preferred and common stockholders split the remaining $2 million based on their ownership percentage on an as-converted basis |
$2.00 million | $1.00 million |
| Participating preferred with a 2x participation cap | (1) Preferred receive $1 million (2) Preferred and common stockholders split the remaining $2 million based on their ownership percentage on an as-converted basis |
$2.00 million | $1.00 million |
| Type | Payout if company sells for $4 million | Payout to Preferred | Payout to Common |
|---|---|---|---|
| Non-participating preferred | (1) Preferred foregos liquidation preference (2) Common and preferred are paid out based on ownership percentage on an as-converted basis. |
$2.0 million | $2.0 million |
| Fully-participating preferred | (1) Preferred receive $1 million (2) Preferred and common stockholders split the remaining $3 million based on their ownership percentage on an as-converted basis |
$2.5 million | $1.5 million |
| Participating preferred with a 2x participation cap | (1) Preferred receive $1 million (2) Preferred and common stockholders split the next $2 million based on their ownership percentage on an as converted basis (3) Preferred reaches their cap and common stockholders receive the final $1 million |
$2.0 million | $2.0 million |
Scenario modeling with Carta
Do you know what will happen when your company exits? It’s important to be aware of investor rights and preferences, especially while fundraising. Carta’s scenario modeling tool automatically calculates the payout to equity holders assuming standard and non-standard terms. It’s an easy way for companies that are planning to fundraise to ensure they’re in the driver’s seat when the time comes to negotiate terms.
Scenario modeling is included in Carta’s Growth and Scale plans. Learn more about our plans or talk to an expert.
DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.
