The Perils of Liquidation Waterfall: Part 2

By Sonit Agrawal Apr 24, 2018

In our last post, we discussed investment scenarios with only a single investor. However, in reality, most companies have multiple investors investing in multiple financing rounds. In such a case, determining liquidation waterfall becomes extremely challenging. With multiple investors in play, a new clause enters the term sheets – “Seniority”

LLC member distributions

Simply put, seniority is the preference order in which investors get their money back. Also, the seniority ranking is usually allotted to share classes and not individual investors. For instance, Series A would get a seniority ranking of 3 and Seed would get a seniority ranking of 2. Common shareholders usually have the lowest seniority ranking of 1.

Usually seniority preferences flow downward. That is, later investors get higher preference. So, Series A are paid back their dues before Seed investors receive their share of the pie and so on.

Let us assume that FW raises Series A, with VC firm ISA Ventures investing $5m for 37.5% stake in FW. The updated captable would look like this.

Investor Share Class Investment (in USD) Fully Diluted Stake
ISA Series A $ 5,000,000 37.5%
MPG Seed $ 3,000,000 25%
Founder Common $ 10,000 37.5%

The share class details would be as follows

Share Class Liquidation Preference Preferred Participation Participation Cap Cap Multiple Seniority
Series A 1x Yes Yes 2x 3
Seed 1x Yes Yes 2x 2
Common No No N/A 1

In case of an liquidation event, first the Series A shareholders would be paid back followed by Seed shareholders followed by common shareholders

a. Liquidation preference proceeds flow down based on seniority

As seen in figure 1, till a value of $5m only Series A shareholders are paid back. After that Seed shareholders join in. Common shareholders join in the last – at an exit value of $8m.

Sometimes, this structure might be reversed – later investors might be paid after early investors. Seed would be paid back before Series A. This structure is not very prominent and rarely practiced.

Finally, seniority might be pari passu. Investors across all stages have the same seniority status. In this situation both Seed and Series A would have same preferential rights over exit proceeds.

Pari Passu
Pari Passu
b. Pari-passu keeps it simple

Here, both Seed and Series A start sharing proceeds at the beginning itself. Initially, as the exit proceeds are insufficient to cover liquidation preferences of both Seed and Series A, exit proceeds are shared in proportion of amount invested till $8m, at which point the exit proceeds are sufficient to cover liquidation preferences of both the share classes. Common shareholders join at an exit value of $8m after which the proceeds are shared on a proportionate basis of the FD stake.

Finally, there might also be a hybrid of pari-passu and usual seniority – i.e some classes might be pari passu within themselves but senior to other classes. Let’s take a hypothetical example.

Share Class Liquidation Preference Preferred Participation Participation Cap Cap Multiple Seniority
Series D 1x Yes No N/A 4
Series C 1x Yes Yes 3x 3
Series B 1x Yes Yes 3x 3
Series A 1x Yes Yes 2x 2
Seed 1x Yes Yes 2x 2
Common No No N/A 1

Here, Series D shareholders hold the highest seniority among all classes and would exercise their liquidation preference before other shareholders can participate. Then, Series B and C shareholders would exercise liquidation preferences proportionately. Finally, Series A and seed would come in and start participating. In a sample scenario below, Seed and Series A get to participate only after the first $76mn have been distributed.

Liquidation Preference Breakpoints
liquidation preference breakpoints
c. The wait is long for lower seniority shareholders

Clearly, seniority is important, especially if the exit value isn't as high as expected. Senior classes will take the lion’s share of the proceeds and leave nothing on the table for junior classes.

Gap in expected proceeds and actual proceeds increases as more and more financing rounds happen due to stacking up of seniority levels and liquidation preferences of late investors. You might expect 30% of the proceeds but end up receiveing a much lower share due to liquidation preferences.

gap between expected and actual proceeds

The best way to minimize this gap is to know beforehand the impact of future investors’ liquidation preferences and seniority are going to have on your returns and use this knowledge to negotiate accordingly.

Editor's note: This post was updated to include visuals from the Fundwave exit waterfall scenario modelling tool.

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