Decoding Term Sheet: Liquidation Preference | Particiaption & Non-Participation Rights
Decoding Term Sheet: Liquidation Preference | Particiaption & Non-Participation Rights
1X, 2X Liquidation Preference with particiaption & Non-particiaption Right | VC Jobs
Imagine this scenario: You're buzzing with excitement over your brilliant startup idea, and a venture capitalist shows interest in funding your venture. But hold on a second, there's a crucial hurdle to overcome: term sheets. Suddenly, terms like "1x participation" and "non-participation" start popping up, and you're left scratching your head, wondering, "Do I really need to understand all this legal jargon as a founder?"
Fear not, because I've got your back! Let's demystify these terms together and make sure you're well-equipped to navigate the complex world of startup financing. So grab a cup of coffee, get cosy, and let's get started!
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Let’s deep dive into it:
I hope you are aware of what is a term sheet. - If not then in the simplest word.
A term sheet is a non-binding legal agreement (non-disclosure and non-sharing) between the founders & investors that shows the investor’s interest in that startup.
Understanding clauses like 1x liquidation participation or non-participation is crucial for both investors and founders in order to protect and maintain the value of their investments during a liquidation event. It is essential for founders to grasp these concepts and make informed decisions about whether a 1X or 2X liquidation preference is the right choice for their circumstances.
Let’s understand this with a simple example:
Consider a startup that got the term sheets from PQR Fund including the investment aspects as follows:
$ Invested: $4M
Pre-Money Valuation: $8M
Post-Money Valuation: $12M
Employee Stock Option Pool: 15%
Liquidation Preference: Let’s take two cases:
Case I: 1X Non- Participating Liquidation
Case II: 1X Participating Liquidation
I hope you are aware of the terms like Pre-money, Post money valuation or option pool. If not then I must say to read our previous writeup on this - Link
If you see the last row, you will find that term called Liquidation Preference. So let’s understand this term first.
Liquidation Preference:
It is the priority that investors have in receiving proceeds (money) from the sale or liquidation of a company. In layman's terms, it means that the investors with a liquidation preference have the first right to get their money back before any proceeds are distributed to other shareholders.
For example, if an investor has a liquidation preference of 1x, they would get their initial investment back before any proceeds are distributed to other shareholders. If the investor has a liquidation preference of 2x, they would get twice their initial investment before any proceeds are distributed to other shareholders. Here In this term sheet, you can see VC fund PQR have 1X liquidation preference. It means in case of liquidation of the company, funds PQR first received the initial invested amount back before any proceeds are distributed to other shareholders.
There are two other terms also involved in it - participation and non-participation liquidation preference. Let’s understand both the terms, participation, and non-participation liquidation preference.
Non-Participation Liquidation Preference:
Upon liquidation, non-participating investors have the choice of receiving their funds in one of two ways: either based on a 1X preference or according to their stake in the company. Investors typically compare the potential returns from each option and select the one that would provide the most benefit for them.
Ex - Suppose for fund PQR - if in liquidation (sale) of a company valued at $10 M. let’s calculate the return for investors from both ways:
1. 1X liquidation means investors get 1X of the investment amount - so $4M OR
2. Based on the percentage of stake - 33% * $10M (Valuation) - $3.3M.
So after calculation, it’s clear that option 1 - 1X liquidation preference gives more return to the investor hence he will choose the 1X option and get a return of $4M. And the rest amount of $6M ($10M - $4M) will distribute to other shareholders.
Participation Liquidation Preference:
During the liquidation of a company, investors with a participation liquidation preference are entitled to receive their funds through both methods - a 1X preference and a percentage of their stake in the company.
Ex - Let’s take the same example as above if the fund PQR took the 1X participation liquidation preference then the calculation would be the same - but investors will get a return from both ways so 1X liquidation preference = $4M and Based on percentage stake = $3.3M. So total return for the investor = $4M + $3.3M = $7.3M and the rest amount of $2.7 ($10M - $7M) will be distributed to another stakeholder.
As a founder, if your company is liquidated and there is a participation liquidation preference in place, your returns will be minimal. Therefore, it's advantageous to have a 1X non-participation liquidation preference in the term sheet. Additionally, most venture funds typically use a 1X non-participation liquidation preference as it aligns the interests of investors and other stakeholders in the event of company liquidation.
I hope this write-up will help you to understand these clauses.
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