The Liquidation Preference Effect

Your Equity Could Be Worth Millions — Or Nothing

In 2014, mobile security startup Good Technology was valued at $1.1 billion. Employees thought their equity packages were winning lottery tickets. They were wrong.

One year later, Good sold for $425 million. Employee share prices tumbled from $4.32 a share to $0.44. While executives made millions, employees — some of whom paid $100,000+ in taxes on their equity — made next to nothing.

Good Technology’s situation isn’t uncommon. Like so many startups, it had investors and board members whose equity was protected by high liquidation preference — a guarantee that they get paid first and at least a certain amount when the company sells. When startup investors make millions in a sale, but money runs dry before reaching employees, a bad preference stack is often the cause.

To avoid being surprised when the company you work for is acquired, you need to understand what preferences are, why they’re important, and how you can negotiate around them.

What A Preference Stack Is & Why Startups Need Them

If your equity package works out to 0.1% of the company, shouldn’t you be entitled to 0.1% of the acquisition? Startup financing isn’t that simple.

When a startup is sold, the money it makes is paid to shareholders in a predetermined order, called its “preference stack.” As a rule, employees are last, while shareholders with liquidation preference (LP) come first.

Three factors affect liquidation preference, and understanding them can give you a better sense of who gets paid how much and when:

• Multiple: This decides how much money an investor will be paid. A 1x multiple — standard for mid-stage companies — guarantees the investors get 100% of their money back. Higher multiples become more common in later-stage companies.
• Seniority: This is an investor’s place in the preference stack. Most unicorns have a “pari passu” structure, in which all investors with liquidation preference are paid simultaneously. However, between 2015 and 2016, there was a 60% increase in deals that gave “senior” preference to later-stage investors — meaning they get paid first.
• Participation: There are two types. In standard, “non-participating” preference, an investor with a 1x multiple and 10% ownership chooses to either be paid 1x of their investment or 10% of the acquisition price. In “participating” preference, the investor gets both. The latter arrangement is rare — as of 2014, only 31% of deals included participating preference, and they generally include a payout cap.

The more rounds of financing a company raises, the more complicated its preference stack becomes. Eventbrite is a good example. At the time of its August IPO filing, the company had eight classes of preferred shares, average among unicorns. While Eventbrite’s Series A through F-1 had been raised at 1x multiples, its Series G was raised at a 1.5x multiple, and the resulting liquidation preference was huge:

While large preference stacks could ultimately mean less money trickles down to employees in a sale, they exist for good reason: Liquidation preference give investors the protection they need to make the high-risk investments that startups thrive on.

Imagine an investor puts $3 million into a young, eight-person company. In return, the investor gets 20% of the company. The two cofounders retain 70% of the company, and the other 10% is split evenly among the six employees.

If the company sells two month later for $5 million, the payouts would look like this:

• The investor’s 20% would be worth $1 million
• Each cofounder’s 35% would be worth $1.75 million
• Each employee’s 1.66% would be worth $83,333

The founders become millionaires, and the employees each get a payout, but the investor loses $2 million. If there had been a 1x liquidation preference in place, the investor would be guaranteed to get $3 million back.

How Liquidation Preference Controls Employee Equity

Imagine you get offered your dream job. The startup is growing fast, and the press has been lauding it as a future unicorn. The company offers you an equity package that works out to 0.15%. Fantastic, right?

Well, how good that deal is or isn’t depends on the company’s preference stack. If the startup is carrying a huge preference overhang, then your 0.15% may be worth very little. Imagine the company’s funding history breaks down like the table below. This is a very simple model, but you can see how the total amount of preference accumulates from round to round:

Seed $1,000,000 1 $1,000,000 Series A $6,000,000 1 $7,000,000 Series B $25,000,000 1.25 $38,250,000

To get a better sense of how preference could affect employee payout, take a look at the table below. It tracks the final value of your equity package depending on the startup’s sale price:

0.15% $75,000,000 $5,000,000 $105,000 0.15% $75,000,000 $25,000,000 $75,000 0.15% $75,000,000 $50,000,000 $37,500 0.15% $75,000,000 $100,000,000 $0

The basic math is simple: In order for your shares to be worth anything, your company’s sale price needs to meet or exceed the value of its preference stack. The more money a startup raises, the harder it gets to fetch a high enough acquisition price.

As Ilya Strebulaev, a professor at Stanford, notes in a study, “Some unicorns have made such generous promises to their preferred shareholders that their common shares [the share’s employees get] are nearly worthless.”

How To Ask About Your Preference Stack

As an employee, there’s not much you can do to affect your startup’s preference stack. You can, however, understand what you’re up against. When you’re considering an offer, or even once you’ve been hired, there are three questions you should ask your employer:

• “What was our most recent valuation?”
• “What is our current yearly growth rate?”
• “How much would the company need to sell for before my equity has value?”

If your most recent valuation is close to or exceeds the needed sale price, your equity offer has value. If the needed sale price is much higher than the company’s most recent valuation, though, you have something to consider: Based on its current growth rate, how many years would you need to stay before its value comes close to that needed sale price? Are you comfortable investing that much time?

Equity alone should not decide whether you join a startup. A high salary, a great growth opportunity, or a mission you feel passionate about can all make up for a modest equity package. The important thing is to have realistic expectations about how much money your equity could turn into.

Originally published at angel.co.