Understanding Liquidation Preferences in Venture Capital and Angel Investing

When it comes to startup financing, the terms and conditions can become quite nuanced. One aspect that often raises questions is the liquidation preference. Specifically, angel investors and venture capitalists (VCs) might wonder if the terms of their investment will be the same. This article delves into the common norms and expectations around liquidation preferences in fundraising rounds and provides insights into why such arrangements are relatively rare.

Common Expectations and Terms in Venture Capital and Angel Investing

Numerous factors can influence the terms of investment, such as the amount invested, the stage of the company, and the specific negotiations between the investor and the startup. However, in the same fundraising round, all investors are typically expected to be on the same terms. This includes the valuation, liquidation preferences, and other economic terms. This principle is often referred to as ' pari passu' which means 'side by side at the same rate.'

When you invest in a company during a specific round, alongside other investors, you should expect identical terms as everyone else. Any differences in terms would only occur if the investors are in different rounds or due to specific protective measures attached to a certain threshold of investment. For example, an investor who holds a majority of a class of shares might have different rights, but these are not considered general 'stepping up' terms.

The Norm of Equal Treatment

VCs and angel investors in the same round are generally treated equally in terms of liquidation preferences. A venture capitalist with a higher liquidation preference is uncommon and, in most cases, would be considered unfair. Typically, if a venture capital firm achieves a dividend preference that accrues and gets paid upon exit, it is a rare occurrence. Multiple seniority preferences are almost unheard of in the venture capital ecosystem, given the complexity and potential unfairness of such arrangements.

Rare Exceptions and Potential Surviving Issues

While it is theoretically possible to draw up contracts in any manner, the general practice in venture capital and angel investing is to maintain parity. However, there are rare instances where such arrangements might be made, especially with large checks that could affect the liquidation payout structure. In these cases, it is essential to consult with a legal professional to understand the implications and common market terms.

Another possibility is that the liquidation preference structure is complex and dependent on the specifics of the sale of the company. If the proceeds are insufficient to cover the liquidation preferences, the distribution can be quite intricate and might favor investors with larger stakes due to the mechanics of the deal.

Conclusion

The core principle in venture capital and angel investing is to ensure equal treatment for investors in the same round. Any deviation from this principle, such as higher liquidation preferences for VCs, is unusual and generally against the norm. If such an arrangement is suspected, it is crucial to seek legal advice to understand the implications and ensure fairness.

In summary, while it is theoretically possible for different treatment within a round, it is not common and is generally against the established norms in the venture capital and angel investing industry.