Suppose you invested $500K in an early-stage deep tech startup at a $5M post-money valuation. You own 10% of the company ($500K/$5M). The founders own the remaining 90%.
Unfortunately, the startup doesn’t grow as you had predicted. It has some valuable IP but very few paying customers. The revenue is minuscule even after 2 years. The company is not going anywhere.
A big competitor wants to acquire the company for its IP. It offers $3M to buy the company with its IP rights. The founders gleefully accept the deal. Since you own just 10% of the company, you would get just $300K (10% of $3M) while the founders walk away with a cool $2.7M. You’re not getting even your investment back in this sale. Founders say, hard luck mate. But we have to take the deal to save the company. You feel cheated.
But this will never happen. Why?
Because your liquidation preference rights will save you. Investors ask for liquidation preference when investing in startups. It’s a common practice in the venture capital industry.
Let’s say your liquidation preference is 1x. It means you’ll first get 1x of your original investment back before founders (and other common shareholders) see a dime. As an investor, you own preferred stock in the company, and these shares have a preference over (come above) the common stock (held by founders and employees).
Since your liquidation preference was 1x, you’ll first get your original $500K from the sale proceeds and then founders (& employees if they own ESOPs) will split the remaining $2.5M.
You’re happy that you got your investment back. If your liquidation preference was 2x, you would have got twice your original investment ($1M) before the common stockholders split the remaining money.
Investors take preferred stock with liquidation preference because it protects their downside. It stops founders from selling the company at a lower valuation and walking away with money if they own a majority stake.
1x liquidation preference is most common while 1.5x is also seen in the market. Anything above that is rare and considered founder unfriendly.
What if your liquidation preference was 2x, and the company was acquired for $1M?
In this scenario, you would have walked away with the entire $1M leaving nothing for the poor founders. If the liquidation preference were 2x, founders would have no incentive to sell the company for $1M. They would wait for a better offer.