If you want to set up this share class you need to create a new ‘A Ordinary’ share class see our Knowledge Base Article on Creating a new share class and raise a support ticket stating you want to create SEIS-compliant A Ordinary Shares with 1x liquidation priority.
Our team will attach the relevant wordings into the liquidation waterfall in the articles.
The rest of this Article deep dives into Liquidation Preferences.
This guide includes:
- What is a Liquidation Preference?
- Key Concepts
- Liquidation Preferences in Practice
- Strategic Considerations for Startups
- Alternatives to Consider
- Key Takeaways for Founders
What is a Liquidation Preference?
Liquidation preference refers to the right of investors to receive their investment back, often with some additional return, before other shareholders (like founders or employees) receive any payout in the event of a sale, merger, or liquidation of the company. This is a common term in venture capital and helps protect investors in high-risk startups, ensuring they recover their capital if the company is sold or doesn’t perform as expected.
Key Concepts
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1x Liquidation Preference: Investors receive 1x their initial investment amount before other shareholders in a liquidation event.
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Non-Participating Liquidation Preference: Investors get back their initial investment but do not participate further in the payout after this amount is returned.
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Participating Liquidation Preference: After getting their initial investment, investors participate alongside other shareholders for any remaining proceeds. This is less favourable to founders.
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SEIS/EIS: The UK government’s Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) offer tax reliefs to investors in early-stage companies but often have limitations on liquidation preferences to retain favourable tax treatment.
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Ordinary Shares vs. Preference Shares:
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Ordinary Shares: Proceeds are distributed proportionally to shareholding in a sale or liquidation. This is 'normal' in early stage funding rounds involving angel investors.
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Preference Shares: Investors are paid first, up to their preference amount, before remaining funds are distributed.
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Liquidation Preferences in Practice
Standard Preferences in Early-Stage Startups
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1x Non-Participating Liquidation Preference: Common and founder-friendly, this protects investors without heavily diluting founders’ stakes.
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Participating Preferences: Rare in early rounds as they are seen as investor-favorable.
SEIS/EIS Compatibility
- Restrictions: SEIS/EIS investments in the UK require that investors face the same risks as other shareholders. Preference shares typically do not qualify but can be structured with compliant alternatives like "Liquidation Priority on Exit" using shares with specific distribution terms. Whilst these shares are technically SEIS/EIS compatible, they are very unusual in practice and shouldn't be routinely offered to investors if it can be avoided.
Strategic Considerations for Startups
1. Pros of Offering Liquidation Preferences:
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Attracts Investors: Offering a 1x non-participating liquidation preference may make your startup more appealing to VCs and other investors, as it provides a safety net if the company underperforms.
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Limits Impact on Ownership: Non-participating preferences do not impact founders’ and employees’ stakes in cases of success; they merely provide the investor with their initial return in downside scenarios.
2. Cons of Offering Liquidation Preferences:
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Creates a Precedent: Offering a liquidation preference may set an expectation among future investors, potentially leading to requests for even higher-ranking preferences.
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Preference Stacking: As more rounds of funding occur, later investors may demand a superior preference. Over time, this can erode founders' and employees' stakes if the exit value is limited.
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Complexity in Exit Scenarios: Preference structures can complicate negotiations in exit events. If the company doesn’t perform well, preferences may mean that common shareholders (founders/employees) receive little to nothing in a sale.
Alternatives to Consider
1. Cap Participating Preferences: If an investor insists on a participating preference, consider capping their participation at a certain multiplier (e.g., 2x) to balance the benefit between investors and founders.
2. Convertible Notes or SAFE Agreements: These structures often delay the issue of liquidation preference until a later stage, allowing the startup more flexibility in early rounds.
3. Avoid Preference Stacking: If offering liquidation preferences, negotiate terms to limit future rounds from having higher-ranking preferences to protect earlier shareholders.
Key Takeaways for Founders
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Market standard: Most UK angel investors will look to make use of SEIS/EIS and will not normally expect to benefit from a liquidation preference in addition to the protections offered by those schemes. Investors that can't make use of SEIS/EIS - for example foreign investors or VCs - may well ask for a liquidation preference though.
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As a fallback: A 1x non-participating liquidation preference is often the fairest compromise between protecting investors and preserving founder equity.
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Caution with Terms: Be wary of setting terms that could disadvantage founders and employees in the long run.
By carefully considering liquidation preferences and their implications, early-stage startups can structure funding agreements that protect both investor interests and long-term founder equity.
