As shareholders of startups, we all know how it’s supposed to work. We make an investment. The company grows. The company is acquired or goes public. Our initial investment yields a stupendous return.

Let’s do the math! Suppose we invest $25K at a $2.5M valuation. We own 1% of the company. A few years later, it is sold for $100M. We get 1% of $100M = $1M; a remarkable 40x our initial investment. Yay!

But, what if the company is sold for only $1M? Then, we get just 1% of $1M = $10K. Not so good, but it’s not like the math is any different. Right?

Well, that depends. Were there any liquidation preferences?

When a company is sold for a relatively small amount, liquidation preferences (or “liq prefs”) provide an investor with a disproportionate share of the proceeds. In the example above in which the company was sold for just $1M, if we have “3x liq prefs”, then we will get $30K, rather than just $10K.

Of course, there is still only $1M to distribute amongst all of the shareholders, so some other shareholders (typically the founder, CEO, and employees of the company) will get less of the proceeds than their percentage of ownership would otherwise entitle them. There’s a lot of additional complexity around liq prefs, including the question of whether investors with these preferences “participate” after receiving their extra money, but the basic idea is simple: investors with liquidation preferences have the first claim on the proceeds of a sale, up to some multiple of their initial investment.

I recently participated in an investment where liq prefs had a significant impact. The company raised money in three rounds:

1. In May, 2015, the company raised money at a $6M valuation.
2. In December, 2015 the company raised more money $10M valuation.
3. In December, 2016 the company raised yet more money at a $15M valuation.

The third round carried 4x liquidation preferences. Therefore, an investment of $10K in Round #3 entitled the investor to $40K in a sale before investors in Round #1 or Round #2 got any payout. I did not participate in the 1st round, but invested in the 2nd round and the 3rd round, investing the same amount of money each time.

This summer, the company (lets call it Company A) agreed to be acquired by another (later-stage) private company (Company B) in a stock transaction. So, after the sale closes, I will own shares of Company B rather than Company A. The valuation of Company B implies a deal value of just $1.5M. And, because Round #3 had 4x liq prefs, and the total investment in Round #3 was more than $500K, all of the proceeds of the deal will go to the Round #3 investors, while Round #1 and Round #2 investors will lose their entire investment. (I show a paper gain on my overall investment in Company A because the 4x liq prefs more than compensate for the loss of the funds I invested in Round #2.)

Several important lessons:

1. Deal terms matter. It’s easy to focus on valuation, but all the other terms (liquidation preferences, warrant coverage, pro rata rights, etc.) can have a significant impact on outcomes. Round #3 paid off (modestly) for investors only because of the liq prefs.
2. Different investors can experience very different outcomes from investments in the same company. A Round #1 or Round #2 investor got nothing, but a Round #3 investor did OK, even though both invested in the same company.
3. Company outcome is different from investment outcome. From a corporate perspective, a $1.5M sale is a disappointment. But, a Round #3 investor isn’t horribly disappointed. A savvy investor might have looked at the company at the time of Round #3 and realized (unlike me) that the company wasn’t on a good trajectory. That investor might have chosen not to invest in Round #3. But, in retrospect, I got an acceptable investment outcome, even though the corporate outcome was poor.
4. Recapitalization comes in different forms. The liq prefs on the Round #3 deal meant that the company had to be sold for a relatively large amount of money before earlier investors would see a good return. When a company finds it challenging to raise money, it may be able to sweeten the deal enough to attract new funds — but in so doing existing investors may find that their shares are devalued by more than the nominal dilution implied buy issuing new shares.

Epilogue

After I wrote an initial draft of this post, I learned that the deal terms may change because the investors in Round #1 and Round #2 are unhappy.  Company B is requesting that all Company A shareholders approve the deal, even though that is not legally required, because Company B does not want any risk of litigation with former shareholders of Company A. Although a majority of shareholders may be able to authorize a transaction, a buyer may not be willing to do a transaction without approval of other shareholders. It takes two to tango!