A company or a startup may need to be liquidated or sold to a different entity in certain circumstances. In such circumstances, the company’s investors need to be compensated for their share in the company.
The ‘liquidation waterfall’ is a term used to refer to how the company’s existing shareholders will be compensated during a liquidation event. Liquidation waterfall is paramount since it can be the difference between getting high returns or no returns at all for an investor.
Legally, the liquidation waterfall is a contractual right. Investors need to agree to their liquidation rights when investing in the company. The shareholder’s agreement will spell out in clear terms the liquidation rights of each shareholder.
Four types of clauses determine the liquidation waterfall of a company. In this article, we’ll take you through each of the four clauses.
Types of Liquidation Clauses
These clauses should be inserted in a company’s shareholders’ agreement to determine the liquidation waterfall. Here is a brief overview of these clauses:
The ‘liquidation preference’ is a clause that determines the amount of proceeds that an investor is entitled to before the company’s common shareholders.
If there is a liquidation event, the preferred investor will be entitled to a certain amount of money as pre-determined by the liquidation preference clause.
Moreover, the liquidation preference clause is usually inserted into agreements to safeguard against events in which the company is sold for a less-than-expected amount.
Ideally, the liquidation preference allows investors to recover at least the amount they invested, even if they don’t make a profit or get positive returns.
The liquidation preference is usually expressed in multiples of the invested amount. For example, the investor may be entitled to 1x or 2x of the amount that she has invested.
For example, a company Horntell has raised seed money from an investor called Ribbon amounting to $1,000,000. Let’s see how much money Ribbon will be entitled to during a liquidation event:
It is evident from the above example that the amount of money that the investor receives at the time of liquidation is wholly determined by the liquidation preference.
Ribbon will receive most of the proceeds from the liquidation due to their liquidation preference.
The ‘participating preference’ is another liquidation waterfall clause that can be added with the ‘liquidation preference’ clause. The participating preference clause allows an investor to receive an additional percentage of the remaining proceeds of a liquidation event once their liquidation preference has been exhausted.
The participation preference allows an investor to be fairly compensated for their investment by ensuring that the investor gets a pro-rata share of the remaining proceeds. This type of clause can be considered unfriendly to founders since it can significantly dilute their proceeds.
Let’s continue the above example. Suppose that the total shareholding percentage of Ribbon in the company was 60%. Then, Ribbon would be entitled to an additional 60% of the remaining proceeds after Ribbon received proceeds.
The table below makes it clearer:
As is evident from the example, the participation preference allows an investor to “double-dip” on the proceeds of a liquidation event.
The ‘participation cap’ is a clause used to limit the amount of proceeds that an investor can get. This clause balances the scales and ensures that the founders and other shareholders get a higher share of the proceeds.
The participation cap is quite simple. It means that the total proceeds that an investor can get are limited to a certain multiple of their investment amount.
To understand this better, let’s continue with the previous example:
In this example, Ribbon’s proceeds from the liquidation are limited due to the participation cap.
As is evident, the participation cap clause can severely limit the proceeds of an investor. In the above example, a “2.5x” limit means that the investor cannot receive more than $2,500,000 on an investment of $1,000,000 under any circumstances, leaving more of the pie to the other shareholders.
The examples laid out above consider a situation where there is only one investor. However, usually, startups have multiple rounds of investment spanning several investors. The “seniority” clause helps determine which investors will be paid back first and which investors may lose out.
The “seniority” clause flows downwards. This means that the later investor gets priority over an earlier investor.
Hence, the founder will be given last priority, while the seed investor will be given second-to-last priority, and the Series A investor will get priority during a liquidation event.
While investing, investors need to negotiate the liquidation waterfall to protect their interests carefully. Unfair liquidation waterfalls can severely restrict the proceeds of investment during a liquidation event of the investee company.
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