I recently dipped into the ICAEW’s useful seminar on valuation of highly leveraged shares provided by PwC.
What is interesting is with the recent decline in VC funding over the past 2 years, pressure on exits and the background of a global trade war, the VC market place is looking like heading toward troubled waters, if it is not already in them.
Most deals until now have seen non-participating preference shares. But could the increased uncertainties result in more participating preference shares being used in current VC rounds.
The recent HSBC Innovation Banking VC term sheet guide 2024 highlighted that 80% of deals issued preference shares, 90% were non-participating and 73% were senior ranking. (https://www.hsbcinnovationbanking.com/en-gb/campaigns/venture-capital-term-sheet-guide-2024).
Liquidation preferences are a critical aspect of venture capital and private equity investments that can significantly influence the financial outcomes for founders and employees. These preferences ensure that investors recover their investments and any accrued dividends before any remaining proceeds are distributed to common shareholders. While this mechanism protects investors, it can sometimes leave founders and employees with little to nothing from an acquisition.
Some recent, extreme examples include:
1. Good Technology: Acquired by BlackBerry in 2015 for $425 million, Good Technology’s founders and employees received very little due to the liquidation preferences held by investors. Despite the high acquisition price, the preferences ensured that investors were paid first, leaving minimal proceeds for common shareholders.
2. Divvy: This rent-to-own startup was acquired for $1 billion. However, common shareholders, including founders and employees, received nothing from the sale due to liquidation preferences. This case underscores how significant the impact can be, even when the sale price is substantial.
3. Freetrade: Acquired by IG Group for £160 million in January 2025, Freetrade’s early investors saw significant returns. However, some later-stage crowdfunders faced losses exceeding 80% of their investments due to liquidation preferences and overinflated valuations. This example highlights the risks associated with liquidation preferences in later-stage investments.
4. FanDuel: Acquired by Paddy Power Betfair (now Flutter Entertainment) for $465 million in 2018, FanDuel’s founders and employees received nothing due to the liquidation preferences held by investors. The preferences entitled investors to the first $559 million from the sale, leaving no proceeds for common shareholders.
Beware “Double Dipping”…
When a company lacks leverage, investors who perceive high risks might negotiate for “participating preferred shares,” also known as the “double dip”. This is something to be avoided, if at all possible.
In a liquidation event, an investor with participating preferred rights is first in line to recoup their initial investment. If any proceeds remain after that, the participating preferred investor will receive an additional share proportional to their ownership stake in the company, on a pro-rata basis with common shareholders. (Pro-rata means that the allocation will be distributed equally.)
The double dip involves both a preference element and a participation element.
The Importance of Share Class Valuations:
Understanding the valuations of each share class during investment rounds is crucial for founders. Each share class can have different rights, preferences, and conversion features, which impact the overall distribution of proceeds in an exit scenario. For instance, preferred shares often come with liquidation preferences that prioritize their payout over common shares.
Valuing each share class accurately ensures that founders and employees are aware of the potential financial outcomes and can negotiate terms that align with their interests. This involves considering factors such as the liquidation preference multiples, participation rights, and conversion ratios.
By being informed about these valuations and their implications, founders can better navigate investment negotiations and protect their financial interests.
These examples illustrate the importance of understanding liquidation preferences and their potential impact on financial outcomes. As founders and employees, it’s crucial to be aware of these terms when negotiating investment deals to ensure fair and equitable treatment in the event of an acquisition.
