Industry insight article – fundraising 101: Understanding Liquidation Preference

By Gabriel Li and Dr Jeremy Loh

If you are looking to raise a round of equity financing, or have raised a round before, then you are very likely to have come across the term “liquidation preference”. A quick online search might have brought you to articles written by Investopedia or Corporate Finance Institute which provide a general description of the term. However, these write-ups tend not to be jurisdiction-specific, or tailored for your objective as a founder looking to raise monies to be injected into a Singapore private limited company.

Today, as a member of the Venture Capital Investment Model Agreement 2.0 (VIMA 2.0) working group which is a joint initiative between the Singapore Academy of Law and the Singapore Venture and Private Capital Association, I pen down an introduction of this term to explain liquidation preference to founders looking to raise institutional capital. In each section, we also include some pro tips from seasoned veterans in the venture capital ecosystem. This time, we have the fortune of obtaining some invaluable nuggets of wisdom from Dr Jeremy Loh, Managing Partner of Genesis Alternative Ventures, one of Southeast Asia’s premier private lenders to venture and growth-stage companies backed by tier-one venture capitalists.

1. What is Liquidation Preference?

Liquidation preference is a term that determines how the proceeds of a liquidity event are distributed. It is designed to ensure that investors who participate at a later stage (and typically at a higher valuation) with preference shares are paid out before any proceeds are distributed to founders and employees who hold ordinary shares.

Illustration of cash waterfall from a Liquidity Event

In VIMA 2.0 agreements, the liquidation preference term is contained in the shareholders’ agreement and the model constitution.

• It is found in the shareholders’ agreement to the extent that this is a transaction document that would bind all shareholders of the company and is therefore included to ensure all shareholders agree to how proceeds are distributed upon a Liquidity Event.
• It is also included in the model constitution as that is where key preference share terms must be included in order to provide the legal basis for the creation of a class of preference shares. Liquidation preference, being the key aspect of a preference share, would therefore feature prominently in the constitution of a company.

Additionally, the liquidation preference term might be included in passing in (1) the subscription agreement to reference the class of preference shares being subscribed for by an investor and (2) the term sheet where a prospective investor agrees on the class of preference shares it is agreeing to invest in.

The liquidation preference term is critical to founders because it directly impacts a founder’s payout during an exit. Put simply, a founder who manages his/her start-up’s liquidation preference well after each fund-raising round can enjoy the spoils of a favourable exit. Likewise, if the liquidation preference term is not managed well, even the most lucrative of exits might see little left to be paid out to founders when the spoils are enjoyed unequally by the holders of preference shares.

2. Composition of a Liquidation Preference

There are a few parts to understanding a liquidation preference term and in the VIMA 2.0 agreements, these are generally understood in three broad categories:

• Seniority: First, there is the seniority of the class of preference shares. As a rule of thumb, the cash waterfall tends to favour the investors in later rounds over those in earlier rounds. Therefore, a Series A preference share is more often than not senior to a Series Seed preference share and a Series Seed preference share senior to a Series Pre-Seed preference share.
• Multiple: Second, there is the multiple of the liquidation preference (1.0x, 1.5x, 2.0x etc.). In the VIMA 2.0 agreements, this is expressed as a percentage of the “initial subscription price per share”. A 1.0x liquidation preference would correspond to a 100% multiple of the initial subscription price per share paid by the investor. Accordingly, an investor who agrees to a 1.0X multiple can expect to receive at least his/her initial subscription price back during a liquidity event. Likewise, a 2.0X multiple would mean that an investor can take back 200% of the initial subscription price per share, doubling the investment.
• Participating / Non-Participating: Finally, there is the option to provide for participating or non-participating preference shares. The participating feature allows the holder of a preference share to further participate in the distribution of the remaining proceeds alongside the holders of ordinary shareholders, thereby granting them a much larger portion of the proceeds upon an exit. Non-participating preference shares on the other hand are more focused on downside protection as holders of such shares do not participate in the distribution of assets with the ordinary shareholders after they have enjoyed their preferential payout.

Later stage rounds can see variations of the above play out, and there might be caps introduced on the amount that can be received as a result of the liquidation preference term. These are unlikely to be included in early-stage fund-raises in Singapore, or for that fact in the Southeast Asian context, granted that 1.0X non-participating preference shares are (more often than not) the norm here.

3. Worked example of a liquidation preference term in practice

One way of understanding how a liquidation preference term would work in practice would be through the use of a worked example.

In the tables below, we assume that an investor had made a 3-million-dollar investment into a company for 30% of its shares. We then illustrate the payout that the investor would obtain if it had invested and obtained each of the following types of shares.

• Example A: Investor took ordinary shares
• Example B: Investor took 1.0X non-participating preference shares
• Example C: Investor took 1.0X participating preference shares

From the above example, we can observe the following characteristics of preference shares.

• Downside protection: When comparing the exit outcomes in Example A against those of Examples B and C, the downside protection offered to an investor by obtaining preference shares with a liquidation preference becomes apparent. In a distressed exit where the company is sold for $1m only, an investor who had obtained ordinary shares would only be entitled to 30% of the $1m exit proceeds, thereby making a loss. On the other hand, an investor who had opted for preference shares is more insulated as such an investor would have gotten all of the $1m exit proceeds as a result of the liquidation preference if it had opted for.     
   
• Potential to make additional profits: Beyond downside protection, an investor who had opted for preference shares with a participating feature can enjoy additional earnings. This can be noted when comparing the earnings obtained from the $5m dollar exit and the $103m dollar exit in Example C against the amounts received by the parties in Example A.   

In the $5m dollar exit, an investor with participating preference shares is not only able to recoup its investment in full but will make a slight profit when the investor also participates in the additional distributions alongside the ordinary shareholders.

In the $103m dollar exit, the investor with participating preference shares not only takes its initial $3m dollar investment back but also obtains an additional $30m dollars by participating in the additional distributions alongside the ordinary shareholders.

4. What is the market’s position on liquidation preference – 1.0x non-participating preference shares

As mentioned above, early-stage rounds in Singapore and Southeast Asia that are based on the VIMA 2.0 agreements tend to lean towards a start-up-friendly 1.0x non-participating liquidation preference. This is particularly so in Asia where cultural nuances emphasise more on building long-term relationships with founders which might persist into later rounds. Even when the zero-interest environment went away, many start-ups which had great potential and demonstrated strong bargaining power managed to pull off early-stage fundraising rounds with a 1.0x non-participating liquidation preference.

As alluded to in the worked example above, a 1.0x non-participating preference strikes a fine balance between shielding investors with the benefits of downside protection and ensuring that founders are motivated by the upside potential should they grow a thriving and profitable business. Having said that, it is only fair to also note that businesses with less leverage may experience higher multiples ranging from anything between 1.1 to 1.5x multiples on a non-participating basis in their earlier rounds.

5. How can founders prepare themselves to obtain the best liquidation preference out there

Managing liquidation preference begins with understanding and negotiation, and there are many ways that a founder might be able to clinch a round with a better liquidation preference.

• Read up and arm yourself with knowledge: Knowledge is power. Founders looking to raise any institutional money should gain a thorough understanding of how liquidation preference works, including all its nuances, and any information it can gain about a prospective investor. The VIMA 2.0 working group regularly publishes articles about venture capital investments and these serve as a great starting point for any research.
• Know your cash runway: The best time to raise money is when the need for funds is not critically urgent. Always leave a healthy runway and enter into negotiations with a good buffer, especially when due diligence and term sheet negotiations can become protracted. Always remember that a business that needs money urgently has a lot less leverage because it cannot choose to simply walk away.
• Seek professional advice: Founders should work with professional advisors who have run dozens of deals across geographies especially when they intend to run a regional business. Whilst an experienced legal counsel might be a little more expensive, the insight into current market trends and other contractual intricacies might land founders in better stead in time to come.

Conclusion

Liquidation preference is more than just a term in a contract; it is a crucial factor that can significantly impact a founder’s financial outcome in an exit. By understanding its importance, and learning how to manage it during each fundraising round, founders can better navigate its complexities. Always try to sink a 1.0x non-participating liquidation preference and use that as a starting point for negotiations, start early, get as much information about your prospective investor as possible, seek professional advice and, where appropriate and with professional guidance, fall back on the VIMA 2.0 model form agreements.

About the authors

Gabriel Li is Vice President (Legal) at Kredivo Group Limited, a rapidly growing Series D fintech growth start-up providing credit solutions to the underbanked throughout Southeast Asia. He is a member of the VIMA 2.0 working group.

Dr Jeremy Loh is Managing Partner of Genesis Alternative Ventures, Southeast Asia’s premier private lender to venture and growth-stage companies backed by tier-one venture capitalists.

Disclaimer: This article is intended for general information only. It is not intended to be, nor should it be, regarded as or relied upon as legal advice. Readers should consult qualified legal professionals before taking any action or omitting to take action in relation to matters discussed herein. This article does not create an attorney-client relationship and is not attorney advertising. Neither the Singapore Academy of Law nor any of the VIMA 2.0 working group members or contributors takes any responsibility for the contents of this article.