I’ve done 100s of investments in my lifetime.

Here’s one way to save a bad deal (and sometimes even 2x your money):
Two words: Liquidation Preference

If you have no idea what I'm talking about, don't worry.

Liquidation Preference is actually a super simple concept.

Just not when you see this legalese leviathan in a term sheet:
Here’s what we’re working with:

Liquidation = Assets turned into cash (usually after a co. closes)

Preference = You get something before other people

Liquidation Preference = when a company bankrupts/sells, you get your cash before other people
A little more specifically:

If a company is forced to sell, you get your investment back regardless of your % ownership before any common holders get paid.
Let’s break down 4 important features of a liquidation preference:
1. Multiples

The multiple decides how much a preferred investor gets paid before common holders get anything.
Let’s say you’re a VC and put $1M in an ice bath company this year.

Next year, Apple acquires the co. for $10M (iBaths will be the next big thing).

• No liq pref? You could leave with $0
• 1x LP? You get all $1M back.
• 2x? You get $2M before common holders get their payout.
1x-2x is common but can go up to 10x depending on market conditions.

I say you’re crazy if you don’t fight for at least 1x liq pref.

The entrepreneur on the other side of the table is crossing their fingers you don’t ask for any.
2. Participating vs Non-participating

Non-participating LP:

At liquidation, you can EITHER:

• get your LP
• convert your preferred shares to common based on ownership %

You invest $1M in Cold Plunge Studios with 1x non-participating LP for 20% ownership

When they sell to Tim Cook for $10M, your options are:

1) get x1 LP, aka $1M
2) give up the LP & get 20% common stock instead, aka $2M

You’d go with option 2 for more $
Participating LP:

At liquidation, you get BOTH your LP AND owner % of what’s leftover.

So that iBath acquisition would earn you $2.8M:

1) $1M LP
2) 20% of the leftover $9M = $1.8M
Get a participating LP when you can. You basically get to double-dip

But if you’re a founder, you’re better off talking your investors into non-participating LPs..
3. Cap

Participating LPs are fun for investors. Not so much for founders.

To be fairer, most come with a cap.

If our $1M investment w? 1x participating LP had a 3x cap, then we’d get:

• $3M max total
• $1M for sure
• $2M max possible from owner % participation
4. Seniority Structures

Not bad so far, right?

Pretty easy to track all this if there’s only 1 investor on the cap table.

Gets a little more math-y when you bring in other people.

Let’s breeze over 2 structures:
• Standard seniority
• Pari passu
Standard Seniority:

LP payouts go from the latest round to the earliest.

So at liquidation:

Series B investors get their LP before Series A get anything.
In theory, if someone really saw the vision of this cold tub industry & invested $10M w/ a 1x LP in the seed round after you…

Then when the company sold for $10M, they’d get their 10 milly back.

And you’d get jack.
Pari Passu:

Shareholders across all stages have the same seniority status.

Which means everybody gets a proportional chunk of proceeds at liquidation.
You, Investor A commit $1M (10%)
Investor B puts in $4M (40%)
Investor C does $5M (50%)

Then the company’s value tanks & ends up only selling for $6M.

You get $600k
Investor B gets $2.4M
Investor C gets $3M

Next time someone says they were a,

“Pari passu Series A investor of $7M with 5x participating LP at a 4x cap”

You'll know wtf they’re talking about (and you can call them out ‘cause that’s a total BS structure)
I’ve met investors who say liquidation preference is too unfair for common shareholders and founders…

And I’ve met ones who say a deal is unfairly risky without it.

What do you think?
Liquidation preferences are a divisive yet important topic if you want to be a great dealmaker.

Follow at @Codie_Sanchez for more content like this.

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Solid thread. A lot to learn here. Thanks!