What are the risks of using a liquidation preference in partnership exit strategies?

1 Alignment of interests

One of the main risks of using a liquidation preference is that it can create misalignment of interests between the investors and the founders, especially in a flat or declining valuation scenario. For example, if the investors have a 2x liquidation preference and the company is sold for the same amount as the investors' total investment, the investors will get all the proceeds and the founders will get nothing. This can discourage the founders from pursuing a sale that might be beneficial for the company, or incentivize them to seek a higher valuation that might be unrealistic or risky. To avoid this risk, investors and founders should align their expectations and goals, and negotiate a fair and reasonable liquidation preference that reflects the risk-reward trade-off of the investment.

2 Dilution and complexity

Another risk of using a liquidation preference is that it can increase the dilution and complexity of the cap table, especially if there are multiple rounds of funding with different preferences and terms. For example, if the investors have a participating liquidation preference, which means they get their preference amount plus a pro rata share of the remaining proceeds, they can end up with a disproportionate share of the exit value compared to their ownership percentage. This can dilute the value of the common shares held by the founders and early investors, and make the exit negotiations more complicated and contentious. To avoid this risk, investors and founders should keep the cap table simple and transparent, and use a non-participating liquidation preference or a cap on the participation amount.

3 Option pool shuffle

A third risk of using a liquidation preference is that it can affect the option pool and the employee compensation, especially if the option pool is created or increased before a funding round. This is known as the option pool shuffle, which means that the investors require the founders to allocate a certain percentage of the post-money valuation to the option pool, which effectively reduces the pre-money valuation and increases the dilution for the founders and existing shareholders. Moreover, if the option pool is not fully allocated or vested at the time of exit, the investors can claim their liquidation preference on the unallocated or unvested shares, which reduces the proceeds available for the founders and employees. To avoid this risk, investors and founders should agree on a fair and realistic option pool size and valuation, and ensure that the option holders are aware of the liquidation preference and its impact on their payout.

4 Investor reputation

A fourth risk of using a liquidation preference is that it can damage the reputation and relationship of the investors with the founders, the employees, and the ecosystem, especially if the investors enforce their liquidation preference in a way that is perceived as unfair or predatory by the other parties. For example, if the investors have a high liquidation preference and the company is sold for a low price, the investors can end up taking most or all of the proceeds, leaving nothing or very little for the founders and employees who worked hard to build the company. This can create resentment and distrust among the founders and employees, and harm the reputation and brand of the investors in the market. To avoid this risk, investors and founders should communicate openly and honestly, and respect the interests and contributions of all the stakeholders involved in the exit.

5 Legal and tax implications

A fifth risk of using a liquidation preference is that it can have legal and tax implications for the investors and the founders, especially if the liquidation preference is structured or executed in a way that violates the terms of the deal or the laws of the jurisdiction. For example, if the investors have a liquidation preference that is contingent on certain milestones or events, and the company fails to meet those conditions, the investors can lose their preference or face a legal dispute with the founders. Alternatively, if the investors have a liquidation preference that is treated as debt rather than equity, they can face tax liabilities or penalties on the interest or principal payments. To avoid this risk, investors and founders should consult with legal and tax experts, and ensure that the liquidation preference is compliant and consistent with the deal documents and the applicable laws.