The “dangers” of the liquidation preference
Despite blocking so many angel investing “experts,” LinkedIn still fills our feed with plagiarized or AI-generated (or both?) stories on how:
“This founder sold her company for a bajillion dollars and walked away with nothing.”
(Just to prove I’m not making these up, here are just a few for you to endure:
- Entrepreneurs share these heartbreaking stories with VC-influencers. Every couple of weeks with this guy apparently.
- Good exits actually aren’t.
- Attorney-influencers do it. Repeatedly :)
- And it even happens in India!)
These stories are, frankly, duckshit.
But from the comments (of which there must be some that aren’t bots. Right?) they resonate – and people who invest and/or raise capital apparently have no clue about the investments they are making or taking. Yikes.
So that you have no excuse to be surprised by liquidation preferences, here are the key facts:
- Angels and VCs buy preferred shares in companies. Preferred shares mean the shares have a liquidation preference – which means investors get their money back at an exit (aka liquidation) before other shareholders start getting proceeds.
- Liquidation preferences are standard, sensible, not dangerous, not evil. They protect investors seeing their investment immediately disappearing into the pockets of others.
- A 1x non-participating liquidation preference is essentially universal. (CooleyGo tracks this stuff.) It is very difficult to find a company with a 2x participating liquidation preference.
- If you are offered “worse” terms (a higher multiple, or participating preference) it’s because you are less investible, less creditworthy – and investors need better protection or upside than you offer without it. If you can raise money without a higher multiple or participation, you obviously should. “Distressed deals” have higher preferences.
- Preferences “stack”. If you raise 4 rounds of capital, that’s a lot of liquidation preference to pay out at liquidation.
- Liquidation preferences only become relevant if the founder does not succeed. If they turn $20M of investment into $20M of exit value, the founder has basically failed, and they shouldn’t get paid.
- Liquidation preferences are circumvented a lot. Founders almost always get salaries paid along the way, at the very least. At exit, acquirers regularly “carve out” proceeds or transaction bonuses to founders. Later stage investors often eliminate early-stage investors’ liquidation preferences.
The “walked away with $0” trope ignores all these things to bait clicks, and to show how evil venture capitalists and angel investors are. While we no doubt are, liquidation preferences are not why!
Why care? Liquidation preferences are certainly important, but these kinds of stories are likely all fabrications. You should (as an investor or founder) understand liquidation preferences and how they impact distribution scenarios. But if you are ever in a position to complain about them, it’s because something else much worse happened – and you’re complaining about a symptom not a cause