Key Takeaways

  • Convertible note liquidation preferences determine payout priority for investors during liquidity events like acquisitions or IPOs.
  • Early investors often receive preferential treatment due to taking higher initial risks.
  • Overly generous valuation caps or multiple stacked notes can create liquidation overhang, reducing founder and common shareholder returns.
  • Convertible notes may include features such as conversion discounts, valuation caps, and participating vs. non-participating preferences.
  • Founders should carefully negotiate liquidation terms to avoid hidden traps, such as multiple liquidation preferences stacking across financing rounds.

Convertible Note Liquidation Preference Overview

Convertible note liquidation preferences are the terms that define in what order shareholders will be paid should their convertible notes be liquidated at a liquidation event. Although all investors would like to have a higher liquidation preference, early investors are generally given liquidation preference over later investors due to their shouldering of greater risk at the outset.

Risks of Multiple Liquidation Preferences

While liquidation preferences provide downside protection for investors, problems arise when multiple rounds of convertible notes are stacked. Each round may carry its own liquidation preference, which can compound in a liquidity event. For example, if a company issues several notes with varying caps and discounts, these preferences may multiply, leaving founders and common shareholders with little to no payout.

This phenomenon is sometimes called a “double-dip” or multiple liquidation preference trap. Investors may recover their principal with interest, then also participate in equity upside. Without careful negotiation, this structure can unfairly shift risk onto founders.

Convertible Note Valuation

The convertible notes themselves are financial instruments regularly used to raise capital in the early stages of a company’s life. These notes commonly have a valuation cap that sets the maximum value that the note can be converted to in subsequent financing rounds regardless of the value set in that particular financing round. Such notes are meant to reward older investors by letting them convert their notes into equity at a lower price than that of so-called “new money” investors.

If a note is set with a low valuation cap, this could result in a new round of financing with a value that exceeds that of the cap, which will, in turn, allow early investors to get a liquidation preference that was much higher than was intended. This means that the investors will, in fact, receive more money than the founders of the company. This occurs more often with companies that have more difficulty in raising funds, as they have little leverage for negotiations in this regard.

This problem has become even worse recently, with the evolution of convertible notes from short-term bridge loans to long-term loans that may last several years. This lengthening of the time frame increases the risk of greater changes in the valuation of the note over the length of the loan. The resulting problem–investors being owned too large a payout–can be avoided with careful planning at the outset, otherwise, the only other recourse is to ask investors to yield some of their rights, which is never popular.

Convertible Note Overhang

Convertible note overhang occurs when too many notes accumulate before a priced equity round. Because these notes convert into equity at discounts or caps, they can heavily dilute founders and early employees once a priced round or liquidity event occurs.

This overhang not only dilutes ownership but also distorts liquidation preference payouts. Later investors may hesitate to fund companies burdened by large amounts of outstanding notes, since repayment or conversion could leave little room for new equity incentives. Founders should monitor the size of outstanding notes and avoid excessive reliance on them.

Convertible Note Liquidation Preference Terms

Some important terms to know when dealing with convertible note liquidation preferences include:

  • Conversion cap. This refers to the maximum value a company may have while the note’s owner can still convert it into shares, regardless of the company’s actual value. A note may be converted at a triggering financing event.
  • Conversion discount. This lets a convertible note holder pay a lower price for each share when converting them into shares in the triggering financing event. Investors who participate in triggering financing events have usually purchased preferred stock of the company at hand. Preferred stock will usually permit the holder to convert it into common stock at any time so long as certain terms are met.
  • Liquidity event. This is an event that in turn triggers a payout for investors. Such events could include an initial public offering (IPO) or an acquisition.
  • Liquidation preferences. This refers to the contract terms that determine who will get paid what and in what priority in a liquidity event. The two types of liquidation preferences are non-participating and participating.
  • Non-participating liquidation preference. This type of preference gives liquidation preference to preferred stockholders over common stockholders equal to the price they paid per share or some multiple of the share price. With this, shareholders have the choice to convert their shares into common shares if they want. If they do not convert, then they will be paid the amount of their note plus interest before common shareholders may gain any proceeds from the liquidity event. If they do convert, then they will be paid what was loaned to the business first with interest, then share in any gains made by the liquidity event on a pro rata basis.
  • Participating liquidation preference. This type of preference is the same as a non-participating preference, except that in this case the holder of the preference, should they convert, will be paid what was loaned to the business first with interest, then a pro rata share of the common stock profits before other distributions are doled out to any remaining shareholders. Normally, there is a 1:1 conversion ratio between preferred and common stock, although this could be higher pending negotiation.

Participating vs. Non-Participating Preferences in Practice

In practice, the distinction between participating and non-participating liquidation preferences has major financial implications:

  • Non-participating preference: Investors must choose between taking their liquidation preference (return of principal plus any agreed multiple) or converting into common equity to share in the upside.
  • Participating preference: Investors can first reclaim their invested principal (plus multiples) and then also share in remaining proceeds as equity holders.

While investors often push for participating preferences, founders should recognize that this significantly reduces their potential payout. Many negotiation strategies include:

  • Capping the participation amount (e.g., 2x return maximum).
  • Converting participating preference into non-participating after a set time.
  • Using clear caps to prevent unintended investor windfalls.

Frequently Asked Questions

  1. What is a convertible note liquidation preference?
    It is a contractual term that determines how and in what order investors are paid during a liquidity event, such as an acquisition or IPO.
  2. Why do investors want liquidation preferences?
    They provide downside protection by ensuring investors recover their principal (sometimes with interest or multiples) before common shareholders are paid.
  3. What is liquidation overhang in convertible notes?
    Overhang happens when too many notes are issued with caps and discounts, leading to heavy dilution and complicated liquidation payouts once converted into equity.
  4. What’s the difference between participating and non-participating preferences?
    Participating preferences allow investors to take their initial investment back and share in equity upside. Non-participating preferences require them to choose one or the other.
  5. How can founders protect themselves from unfair liquidation preferences?
    They can negotiate clear valuation caps, limit participation multiples, and avoid excessive reliance on stacked convertible notes to reduce overhang risk.

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