Raising Real Money
At the beginning of a start-up’s existence, a business usually doesn’t need that much funding to move forward on its critical early goes. As a result, if a company is looking to raise around $1 million or less, the most common approach in today’s fundraising environment is for a company to issue Convertible Notes or SAFEs in a quick, simple financing transaction that normally has low legal costs.
However, once a company is really starting to grow and needs some real cash – usually $1.5-$2 million or more – the investors who are willing to participate at this point usually expect real ownership rights in the business, not just a legal commitment to perhaps get those rights in the future. Consequently, founders need to issue and sell actual shares in their company to these investors instead of issuing Convertible Notes or SAFEs.
What’s a Preferred Share?
The shares issued to investors during these sorts of funding rounds are almost never the same regular “Common Shares” that founders give themselves when a company is initially launched. These ‘equity’ investors are almost always issued a class of shares that give them certain extra rights, advantages, and protections, also known as preferences - thus the term “Preferred Shares”.
What these preferences will be will often vary from deal to deal. And while certain preferences are very common depending on the size of the investment round, ultimately, everything is negotiable – there are no laws stating that an investor must get any particular preference.
Furthermore, the class of Preferred Shares, with its specific set of rights and preferences, that gets issued in your company’s first equity round will almost never be the identical to the next class of Preferred Shares issued in your company’s next equity round which will usually be different from those issued in the round after that and so on. This is not surprising: as your company grows and expands, what your investors will require to sign up to a new financing round will most likely vary as well.
Investors can negotiate for both economic rights and advantages and management-related rights and advantages. In most cases, investors will ask for and get both kinds of rights and advantages.
To keep things simple, in this article we will start our discussion about common preferences by talking about the most common kind of economic preference: the liquidation preference.
What is a Liquidation Preference?
A liquidation preference determines the order in which investors receive money following the sale or wind-up of a company. In almost all cases, the liquidation preference is a multiple of the purchase price for the Preferred Shares (e.g. 1x liquidation preference, a 2x liquidation preference, etc.). There are two kinds of liquidation preferences: a non-participating liquidation preference and a participating liquidation preference.
What is a Non-Participating Liquidation Preference?
The most common type of liquidation preference for Prefered Shares issued in early investment rounds is a non-participating liquidation preference. With this kind of preference, in the event of a sale of the company or a wind-up and liquidation of the company, any money received by the company is first paid out to the preferred shareholders. Anything left over is then paid to everyone else (i.e. the founders holding common shares).
A non-participating liquidation preference is often used to provide some downside protection as well as a relatively reasonable amount of upside if the company does well. If the company is liquidated or sold at a low price, a non-participating liquidation preference means the preferred shareholders will likely get most, if not all, the small amount of money that’s available for distribution while the founders – holding the common shares – will most likely end up with nothing or almost nothing.
In very early rounds, this is very often a 1x non-participating liquidation preference, meaning the preferred shareholders essentially have the right to get their investment back if things go south, or, if there’s not even enough money for that, they at least get 100% of whatever money is available (with the common shareholders getting nothing). And in the event that there is a highly profitable sale where the common shares would get much more than the preferred shares under this allocation formula, the preferred shareholders will simply exercise the right they almost always have to convert their preferred shares into common shares.
What is a Participating Liquidation Preference?
The other common type of liquidation preference is a participating liquidation preference. If a class of preferred shares has a participating liquidation preference, they get two, not just one, bites at the apple.
First, they get their liquidation preference paid to them before anyone else.
Second, they also get a pro-rata share of whatever money is left over for everyone who doesn’t have the same kind of preference (i.e. the common shares). Getting a participating liquidation preference can be very rewarding for an investor, especially if the company has a big exit. Fortunately for early stage startups, this is currently not something that investors typically require in order to participate in early fundraising rounds.
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