What you need to know about liquidation preferences

liquidation preference singapore

It took a while but after refining your business, polishing up your pitch deck, and killing it during the interviews, you’ve finally gotten a few term sheets from Singapore investors on your desk.

Every one of these term sheets seem to bring up a liquidation preference. So just what exactly is this liquidation preference and how does it affect your startup in Singapore?

Now, before we talk about liquidation preferences, we should take a step backwards and start with the basics. Most investors in Singapore will ask for preferred shares as it grants a special set of rights to the preferred shareholders relative to the ordinary shareholders. One of those rights is usually a liquidation preference.

In general, a liquidation preference clause is a primary economic term that impacts how the proceeds will be distributed in the event the startup is sold, has a public offering, is wound up, or has another liquidation event as defined by the investors.

Liquidation preferences can be partial (less than 100%), full (100%) or a multiple of the original investment funds. However, it’s more often than not that the preference will be a multiple of the original investment amount. Usually, this clause becomes particularly important in the event the startup is sold for less than the amount of money invested.

What are the different types of liquidation preferences?

There are three basic forms of liquidation preferences.

1). Non-participating

In general, non-participating preferences tend to be more beneficial to the founders. Typically, this preference stipulates that the investor will receive an amount equal to the initial investment amount when a liquidation event is triggered. In the event the startup has been sold at a high valuation, and the holders of common shares would receive more per share than the holders of the preferred stock (i.e. the investors), then the holders of the preferred stock will convert their shares to ordinary shares in order to share ratably in the overall proceeds.

2). Participating

In general, participating preferences tend to favour the investors. Participating preferences generally receive an amount equal to the initial investment amount in a liquidation event as well. However, participating preferences have an additional advantage in that the preferred shares then “participate” in whatever is left over on an “as converted common stock” basis with the rest of the ordinary shares.

3). Capped Participating

A cap on participating preferences can be seen as a sort of compromise between investors and founders. Basically, it “caps” or tops off the amount received by the preferred shares to a fixed amount. It indicates that the preferred shares will participate in the liquidation proceeds until a certain multiple return is received.

EXAMPLE

A liquidation preference is probably more easily understood in the form of an example. Let’s take hypothetical company SG Startup whose founders hold 3,000,000 shares at S$0.02 per share (S$60,000).

SG Ventures then puts in S$1,000,000 to purchase 1,000,000 preferred shares at S$1.00. The percentage ownership is 75% founders and 25% investors.

Now assume SG Startup has been acquired for a nifty S$10,000,000 and SG Ventures has a non-participating preference of an equal amount to their investment. In this situation, the preference gives them the right to take back their investment of S$1,000,000 but that would be all that SG Ventures would get out of the deal. In this scenario, SG Ventures would probably prefer to convert to ordinary shares and get S$2,500,000 instead.

Now assume the same acquisition of S$10,000,000 but SG Ventures has a participating preference instead. It gets back its S$1,000,000 and shares pro-ratably with the ordinary shareholders after converting its preferred shares to ordinary shares. Here, the total amount SG Ventures will receive is: S$1,000,000 + (0.25*S$9,000,000) = S$3,250,000.

Once again, assume the same acquisition of S$10,000,000 but SG Ventures has a capped preference of 3X. In this scenario, the preference gives them the right to get back S$3,000,000 instead of the S$2,500,000 it would have gotten if it had to convert to ordinary shares.

Examples of a liquidation preference clauses

Non-participating

In the event of any liquidation, dissolution or winding up of the Company, the holders of the Class A Preference Shares shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [X] times the Investment Amount plus any declared but unpaid dividends.

Participating

In the event of any liquidation, dissolution or winding up of the Company, the holders of the Class A Preference Shares shall be entitled to receive an amount equal to the Investment Amount of this financing. After this distribution, any remaining proceeds and/or assets of the Company legally available to the Shareholders shall be distributed pro-rata, according to the respective shareholding percentages of Class A Preference shareholders (on an as- converted basis) and Ordinary Shareholders.

Capped Participating

After the payment of the Liquidation Preference to the holders of the Class A Preference Shares, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Class A Preference Shares on a common equivalent basis, provided that the holders of the Class A Preference Shares will stop participating once they have received a total liquidation amount per share equal [X] times the Investment Amount, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.