If you’re a startup founder in desperate need of an injection of cash, it is tempting to rush into a less than friendly deal. As the wrong investment has the potential to cripple your startup, and leave you walking away with nothing (even after a modest exit!), you should take caution. It’s important to understand what investors are requesting, especially if they request Participating Liquidation Preferences (PLP), and the impact of such investments on your startup.

Liquidation Preferences

While uncommon during early stage investment rounds, investors in larger Seed or Series A rounds may request preference shares. Liquidation preferences are in effect, terms determining how shareholders will be paid out when the company is sold. There are many types of preference terms (and not all investors use the same terminology). The most unfriendly of the preference terms is the Participating Liquidation Preference (PLP). To explain how PLP works, it helps first to understand it’s slightly kinder cousin, Non-Participating Liquidation Preferences (NPLP).

Non-Participating Liquidation Preferences

NPLPs are a way for an investor to mitigate their loss within what can be a very unpredictable situation. They help to ensure that when a business is sold, an investor receives their investment back, even if their percentage of ownership alone does not entitle them to as much.

For example, say an investor is putting in $1,000,000 at a valuation of $10,000,000 giving them 10% of the company. They have negotiated a 1 x NPLP. The founders own the remaining 90% of the business but have ordinary shares. The company starts to fail, and the founders take an early exit, selling the business for $1,500,000. As a result of the investors NPLP shares, they receive their full $1,000,000 back, and the founders have $500,000 to split amongst them. If the investor had an initial issue of ordinary shares initially, they would instead receive $150,000 and the founders, $1,350,000, a considerable difference.

It is uncommon in Australia, but some investors may request a 2x non-participating liquidation preference. If this were the case in the above scenario, the investor would receive all $1,500,000 (short of their entitlement) and the founders would receive nothing.

However, say the company is a success and sells for $20,000,000. An investor with only a 1 x NPLP will still only receive their $1,000,000. For this reason, an investor will generally ask for convertible NPLP shares.

Convertible Non-Participating Liquidation Preferences

These shares allow the investor to convert their preference shares into ordinary shares if the business is going to sell at a price, which would see a return for shareholders. As an ordinary shareholder, they will be paid out in proportion to their percentage equity holding. So, if the company sells for $20,000,000, the investor would receive $2,000,000 (a $500,000 return). Convertible NPLPs are good for an investor as they get the security from a low exit and the opportunity to see value in their investment if the business succeeds.

Participating Liquidation Preferences

PLPs also help an investor recoup their investment amount, but they don’t stop there. Once the investor receives their investment back, they then get to participate in the distribution of remaining proceeds in proportion to their percentage ownership. Keeping with our example, if the company were to sell at a low $1,500,000, an investor with $1,000,000 worth of 1 x PLP would receive their $1,000,000 back first, and then they would receive 10% of the remaining $500,000 leaving the founders with only $450,000.

It is easy to see how this ‘double dipping’ could effectively see founders walking away with nothing. This concept, being as unfair as it is, is also often unanticipated or misunderstood by founders, who may agree to PLPs without considering their effect if things don’t pan out as per their intentions. Further, complicating this by multiple rounds of preference share investors or some asking for 2 x PLP, and a startups capitalisation table is a fast recipe for disaster.

What if an investor asks for Participating Liquidation Preferences?

In Australia, a convertible 1 x NPLP is the most common liquidation preference right. However in the US, participating liquidation preferences of 2x (or even 3x) are common. Australian startups should be wary of the impact of this on the Australian market. It is also important to prepare yourself if an investor requests PLPs.

A 2 x PLP would see an investor receiving twice their investment back, plus their percentage of the remaining proceeds. Therefore a 2 x PLP is unfair for ordinary shareholders and is something that you should steer clear from. As new investors may expect the same terms or completely loose interest upon seeing the cap table, future financing may become difficult.

Imagine you’re a founder with an investor holding 2 x PLP shares. Suddenly your company starts heading on a downward spiral. There may be little incentive for you to make the best out of the situation. Why? Because you are set to receive little for your ownership stake. An incentivised founder is key to a successful business. While an investor who thinks only of their return, could be the very thing that sinks it.

When negotiating share terms, you should first try for ordinary shares. You should explain that all shareholders should be equals and ‘in it together’. If this fails, try offering 1 x non-participating/convertible preference shares as an alternative. The investor will see the value in a fixed return and the option to make a profit through conversion. If an investor insists on PLP, carefully consider the impact on your personal return by forecasting best and worst case exit scenarios. If it all just seems too unfair, this investment is probably not right for your startup. Walk away, and turn your attention to greener pastures.

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If you have any questions about NPLP, PLP or need advice when considering investment offers for your startup, get in touch with one of LegalVision’s startup lawyers on 1300 544 755.

 

Madeleine Hunt
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