Wrong Liquidation Preferences … Or How To Snatch A Loss From The Jaws Of Profit
Pawel Chudzinski, co-founder of Point Nine Capital, explains how the wrong liquidation preferences could leave you massively out of pocket.
Liquidation preferences are, in short, the small print in your contract that determines how the proceeds are distributed in a company sale situation. You may own half the company but end up seeing none of the money when the business is sold (depending on the rights of the various classes of preference shares).
VC firms finding the market a bit rough going at present are resorting to getting “creative” with structures and liquidation preferences in an attempt to hog a larger share of the pie when a business is sold. Pawel explains how it’s done and what you can to do protect against it.
By design, every liquidation preference skews the distribution of exit proceeds away from ownership %-tages. I think this works OK in case of 1x non-participating liquidation preferences, which are irrelevant if the exit price is above the entry price of a negotiated funding round. Multiple and / or participating liquidation preferences can skew distributions much more heavily, even at higher outcomes. This leads to sometimes very different financial incentives for investors vs founders or ESOP holders and in consequence is likely to result in conflicts. An example could be a discussion around a proposed sale of a company at a price that will allow investors to make a nice return, but due to the liquidation preference structure not much would be left on the table for common shareholders…Read the article here.