Founders often ask us how senior debt or liquidation preferences work, so we put together this quick explainer, and tried to do so in “layman’s terms.”
Let’s go to the very beginning. You’ve put a team together and incorporated your company. To keep things simple, you’ve decided to approve 1,000 shares to represent the ownership of your company. “Shares” means the number of slices you want to split the pie into that is your company. You as an individual or as a team can own as many slices as you decide to own (with a maximum of 100% of the shares you approve).
Let’s say you have another cofounder and decide to split it evenly. You each then can own 500 slices each (50% ownership).
On day one, however, you have to consider if you plan to give more shares to additional individuals in the future. Rome wasn’t built in a day, nor was it built with one or two people. You have a choice to make: you set aside shares right now for employees (in what is called an Equity Incentive Pool), which is also used to attract and retain talent, or you add more in the future. Both have more or less the same effect, but it’s always cheaper to get things done right at the beginning rather than adjusting them later.
So, let’s say you plan to give future employees a max of 20% of your company. So you can set aside 200 shares that will be given to employees (employee #1 can get 30 shares, employee #20 can get 2 shares or, up to you).
So this means you own 400 slices, your cofounder owns 400, and 200 are set aside for future employees.
Some founders ask if you can add more shares in the future; The answer is “yes.” One example also allows us to dive deeper into fundraising and liquidation preference.
Making the Pie Bigger
When an investor puts money into your company, you essentially create more shares, meaning you make the pie bigger.
Let’s say an investor comes around and says they think your company is worth $1M. In this case, $1M is referred to as the “pre-money valuation.” If the investor thinks that’s how much the entire pie is worth, then each of the 1000 slices of the pie is worth 1/1000 of $1M, or $1,000.
Let’s say an investor wants to invest $250,000 into your company. The number of shares she will get is equal to the amount she puts in divided by the price per share of $1,000. In this case: $250,000/$1,000= 250. She will get 250 shares (or slices of the pie).
But wait, you and your cofounder own 800, and 200 are for employees. So where does it come from?
Preferred Shares
This is where it gets a bit more complicated. You add on more pie of a different flavor to the existing pie, which when it is sliced, is called preferred shares, which are just for investors.
So, as before there were 1000 shares, now the entire pie is 1000 plus these 250 preferred shares or 1250. The value of each slice of your company hasn’t changed, it is still $1000 each. So, after the investment, your company is worth $1,250,000, because you had the old value of $1M, plus the value of the cash which is worth its face value ($250,000). In this case, $1,250,000 is referred to as the “post-money valuation.”
Because the investor got 250 shares, they now own 20% of the pie (250/1250).
Now, moving into liquidity events.
These shares are preferred because they usually have special privileges assigned to them. Unlike the founders, who usually only put in time and effort and receive “common” shares, the investors put money at risk, so in their eyes they should be treated differently.
One term they usually have is (at least) a 1X liquidation preference. What this is is a term that says (simplistically), “when money comes in from the sale of the company, I get my money back first.”
So, let’s say the company gets an offer to be purchased. There are multiple scenarios. One scenario is a bad one, and you get an offer to be purchased for $600,000. You may have run out of money and if you don’t accept the deal you will have to shut down the company anyways; so, you decide to do it.
With the simple liquidation preference, the investor asks for her money back first. So she gets $250,000 (1X the amount she puts in).
Downside Protection for the Investor
After that, you and anyone else that owns shares splits up the remaining $350K evenly. You and your founder each get your part of your corresponding 400 slices. So, because the investor already got her payout for her 250 slices, you only count the remaining 1000 slices. You get 400/1000 = 40% of the remaining $350K x 0.4 = $140K, so does your cofounder, while your employees split up 200/1000= 20% of $350K x 0.2 = $70K. The liquidation preference, in other words, is a type of downside protection for the investor. While she owned only 20% of the company at the time of liquidation, her preference entitled her to 41.7% ($250K/$600K) of the proceeds.
Another scenario is that it is a happy purchase: somebody wants to buy your company for an amount that is significantly more than what investors put money in at, say, $10 million. In this case, the investor will say “it’s ok, I won’t use the special rights of my preferred shares” and they become shares just like yours. This scenario is simple: everyone splits up the $10M equal to the percent of the slices they own. So, the investor gets 20% (250/1250) of the $10M= $2M. You and your founder each get 32% (400/1250) which is $3.2M each. You’re probably happy, and employees split up $2M.
Preferred shares can have many different terms and “flavors” to them. A final scenario we will go over to demonstrate this is when preferred shares have a “liquidation preference” that is greater than 1X. Let’s say an investor negotiates a 2X liquidation preference and we have the first, “negative,” scenario. A 2X liquidation preference means that, in the case of a not so positive liquidation event, investors will receive two times the money they invested, before anyone else gets to see any money.
Splitting Up the Pie
They put in $250K, so they will first receive 2 x $250K = $500K, and then others will split the remaining quantity ($600K – $500K = $100K). You and your founder each get your part of your corresponding 400 slices. So, once again, because the investor already got their payout for their 250 slices, you only count the remaining 1000 slices. You get 400/1000 = 40% of the remaining $100K, which is $40K, and so does your cofounder, while your employees split up 200/1000= 20% of $100K which is $20K.
We skipped a lot of details, and this is a simplification of the process, but we hope this is helpful on your founder journey.