How do you negotiate the liquidation preferences and the participation rights?

1 What are liquidation preferences?

Liquidation preferences are the rights that investors have to get paid first before the common shareholders (usually the founders and employees) in the event of a liquidity event, such as a sale or a merger of the company. They are usually expressed as a multiple of the original investment amount, such as 1x, 2x, or 3x. For example, if an investor invests $10 million with a 2x liquidation preference, they will get $20 million back before anyone else gets anything.

2 What are participation rights?

Participation rights are the rights that investors have to participate in the remaining proceeds after the liquidation preferences are paid out, in addition to their preferred shares. They are usually expressed as a percentage of the total equity, such as 10%, 20%, or 30%. For example, if an investor invests $10 million with a 10% participation right, they will get $20 million back from the liquidation preference, plus 10% of whatever is left over after paying all the preferred shareholders.

3 How do they affect your returns?

Liquidation preferences and participation rights can have a significant impact on your returns as a founder or an investor. They can change the distribution of the exit value between the different classes of shareholders, depending on the size and the type of the exit. For example, if the company sells for $100 million, and the investors have invested $50 million with a 2x liquidation preference and a 20% participation right, they will get $100 million ($50 million x 2 + 20% of $50 million), leaving nothing for the common shareholders. However, if the company sells for $500 million, the investors will get $150 million ($50 million x 2 + 20% of $450 million), leaving $350 million for the common shareholders.

4 How do you negotiate them?

Negotiating liquidation preferences and participation rights can be tricky, as they involve trade-offs between the investors and the founders. As a founder, you want to minimize the liquidation preferences and avoid the participation rights, as they can dilute your upside and create misalignment of incentives. On the other hand, investors want to maximize the liquidation preferences and secure the participation rights, as they can protect their downside and increase their returns. Here are some tips to help you negotiate these terms: Firstly, understand the market norms and benchmarks for your industry, stage, and geography. Different sectors and regions may have different expectations and standards for these terms. Additionally, consider the valuation and dilution implications of these terms. Higher liquidation preferences and participation rights may justify a higher valuation, but they may also increase the dilution for common shareholders. Lastly, focus on the scenarios and outcomes that matter most to you. Rather than getting stuck on the numbers and formulas, think about how these terms will affect your returns and alignment in different exit scenarios. With this in mind, you can make decisions on whether to accept a higher liquidation preference or a lower participation right depending on your company's exit potential.

5 Here’s what else to consider

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