Startups are risky investments for angel investors, but securing funding from them is essential to building a business. It's risky for angel investors primarily due to the high chances that a startup will fail within its first few stages. Even with the risks, angel investors look for the next big startup in their industry and, in exchange, for equity in the company and a reasonable exit strategy.
Even the best-laid plans can go awry, and angel investors can protect their investments through an often overlooked but critical term used in negotiations, liquidation preferences. Liquidation preferences can help impact the early-stage investors' overall returns and are considered one of the most important decisions of a deal next to the startup's valuation.
A liquidation preference can be complex and challenging as a startup moves through its growth and development and acquires new investors in the process. An angel investor and a startup's founders need to be sure they fully understand a liquidation preference and why they matter.
Why Startups Need Angel Investors to Fund Their Startup
Angel investors are high-net-worth individuals who enjoy investing in startups that align with their interests and in their preferred industry. It's a great way to invest in a potentially high-earning company that can provide considerable investment returns. Angel investors invest in startups but not without significant risk. On average, 90% of startups fail for various reasons, and without a solid exit strategy or liquidation preference, angel investors can lose their money and end up with no earnings.
Startups look to angel investors to provide them with the funds during the initial stages of their startup beyond providing the critical funds to get the startup off the ground. Angel investors can also provide:
- Expertise – Angel investors are often former entrepreneurs and can provide valuable industry expertise. They can provide advice and coaching to help you through the many business decisions you have to make. Their advice can help your startup avoid making costly mistakes that could lead to the eventual failure of the business.
- Networking Opportunities ¬– Because angel investors have been in the industry previously, they have collected a number of connections over the years that can get you in touch with new customers, other potential investors, and business contacts.
- Support – Angel investors have a stake in your company and want to see you succeed. They will provide motivation and support as you grow your startup in ways that can help provide value and lead to a higher chance of success.
- High Amount of Funds – Angel investors has deep pockets that will allow them to invest further in your startup if they can see your determination and drive to ensure your startup is a success.
- No Upfront Costs – Perhaps one of the biggest benefits of angel investors is that the money they provide does not have to be paid back up front. The angel investors receive their money from the equity share or through liquidation preferences should your startup sell.
What is a Liquidation Preference?
A liquidation preference is the order of payout during a liquidity event. A liquidity event is when investors can see their investments converted into liquid assets. A liquidity event can be when the startup goes public, gets acquired or sold, goes bankrupt, or during a secondary market transaction where an investor can sell their ownership stake to a new investor.
The liquidation preference is usually in place to protect investors from events when the startup is sold for less than the initial valuation and may cause investors to earn less than they'd anticipated, if anything at all. Setting up a liquidation preference helps protect investors in one of these event that can provide less desirable returns. The payout order is essential because when a startup gets sold for less than its evaluation, there may not be enough funds for all investors to make their money at least back.
Liquidation preferences ensure investors are made whole by returning the funds they've invested to all investors, if possible, before any other shareholders can cash in. Because of the impact of the financial return, the liquidation preference is a point of careful negotiation before investments are agreed upon between founders and investors.
Why is Liquidation Preference Important?
Liquidity preference can be a major make-or-break decision that impacts the return on your investment in your startup. When negotiating with investors, it can be hard to take liquidation preferences seriously in the beginning stages when you're optimistic about the success of your startup. The reality is you want to be realistic and have a solid exit plan for your investors that doesn't break your bank, and you can guarantee you won't end up financially in the hole no matter the situation.
For investors, the liquidation preferences are a way to protect the investment and can significantly impact their returns. Even in positive outcomes, having a liquidation preference can help boost returns dramatically.
How Do the Liquidation Preferences Work?
The liquidation preference is all about balancing the order in which investors are paid during an exit. As a startup grows and begins to receive new rounds of funding and new investors are introduced, there are additional rights and privileges to consider when determining the seniority structure of the liquidation preferences. There are three common seniority options.
- Standard – The latest rounds get priority over early-round investors. Usually, later-round investors invest more capital in the startup because it's a more developed company at that point and needs a higher amount of funding. Any liquidation event will satisfy series c before series b investors and so on.
- Pari Passu – The Pari Passu seniority structure treats all investors the same. In a situation where the liquidation can't pay in full all liquidation preferences, the payment is distributed proportionately.
- Tiers – Tiers seniority is more of a hybrid approach. It puts rounds of investments into individual groups allocating seniority to one group over the other.
Aside from deciding the seniority of the liquidation, there are several other parameters to consider when negotiating a liquidation preference between all investors. These types of payouts include:
Multiples – Multiples are assigned as a multiple of the original investment. The 1X liquidation preference is the most common and generally achieves a proper balance between the angel investor and the founders and mitigates the risk. Adding in higher multiples can be a barrier for startups to further funding in subsequent rounds because future investors will seek similar terms and negatively impact the gains for stockholders to receive a fair return in a liquidation event.
Participation – Participation liquidation preferences give investors their full liquidation preference before anything is available for distribution among shareholders and the pro rata of any leftover proceeds alongside the shareholders. The full participation liquidation preference allows investors to receive returns twice and is a less-common option.
Non-Participating Liquidation Preference – Non-participating liquidation preferences have the option to require the amount equal to the liquidation preference multiple in addition to unpaid dividends or convert their shares into common stock and participate in the liquidity event with the shareholders.
Capped Participation – Capped participation only allows investors to participate with shareholders until the preferred x-times of the original investment, with x being the previously agreed upon cap. Investors may still have the option to convert their shares to common stock to participate in the liquidity event with the common shareholders.
Dividend Preferences – Liquidation preferences enable investors to get their investment plus and declared divided that have yet to be paid. Dividends are an agreed-upon share of the company's profits, usually in the form of a percentage. The dividends are usually paid out on a set schedule and would need to be considered if the payout comes after the liquidity event. If dividends are accrued or cumulative, the investors receive their investment plus any accrued unpaid dividends.
Liquidation preferences are important to understand because of the variable options that can provide significant returns to the investors and potentially leave shareholders and founders with smaller returns. When discussing liquidation preferences, it's necessary to consider all investors and their preferences in a liquidity event.
As a founder, you want to ensure that all parties involved feel their returns are fair to prevent any misunderstandings. Liquidation preferences alter the payout distribution for all investors, founders, and employees. The more that is promised to an investor, the fewer returns are available for everyone else. It is possible to strike the right balance between all interested parties with careful planning and consideration for all involved. With the right agreement, you can ensure that everyone will work together to ensure the startup is a success.