Should the Series B liquidation preference be senior to the Series A?
Takeaway: There isn’t really a “market” term for this. It depends on the composition of the investor base and what the lead investor negotiates for. Giving the new money a senior liquidation preference may help incentivize them to invest.
When startups raise funds through multiple financing rounds, they often issue different series of preferred stock to investors. Each series comes with its unique set of rights and preferences, including liquidation preferences. One common question that arises is whether the liquidation preference for Series B preferred stock should be senior (i.e., have priority) to that of Series A. In this post, we will explore the implications of such an arrangement and discuss whether it's a wise decision for startups and investors.
Understanding liquidation preferences
Liquidation preferences determine the order in which stockholders receive their share of the proceeds when a company is sold, liquidated, or undergoes a significant transaction, such as an initial public offering (IPO). Investors holding preferred stock generally have a liquidation preference over common stockholders, ensuring that they receive a return on their investment before common shareholders.
The case for Series B liquidation preference being senior to Series A
There are some arguments in favor of making Series B liquidation preference senior to Series A:
Attracting new investors: Making Series B liquidation preference senior to Series A may help attract new investors in the Series B round, as they would be assured a higher priority in receiving their investment back during a liquidation event.
Compensation for higher risk: Series B investors may argue that they are taking on more significant risk by investing in a company at a later stage, and thus deserve a higher priority in terms of liquidation preference.
The case against Series B liquidation preference being senior to Series A
However, there are compelling reasons against making Series B liquidation preference senior to Series A:
Fairness to early investors: Series A investors took on considerable risk by investing in the startup at an earlier stage when the company was less mature and had fewer proven results. Giving Series B investors a senior liquidation preference could be seen as unfair to early investors who supported the company from the beginning.
Discouraging future investments: Creating a hierarchy of liquidation preferences may discourage future investors, as they may be concerned about being further subordinated in the event of subsequent financing rounds.
Complexity in negotiations: Negotiating seniority in liquidation preferences adds complexity to financing rounds and may lead to protracted discussions, potentially delaying the closing of the round and causing friction among investors.
Striking a balance: Pari passu approach
As an alternative to establishing seniority between Series A and Series B liquidation preferences, many startups opt for a pari passu approach. This means that both series of preferred stock rank equally and share liquidation proceeds proportionately. This approach ensures fairness among investors and simplifies negotiations while maintaining the attractiveness of the investment opportunity.
Conclusion
While there may be some arguments in favor of making Series B liquidation preference senior to Series A, it's generally not considered the best practice in the startup world. Instead, a pari passu approach, where both series of preferred stock rank equally in terms of liquidation preference, is often seen as the fairest and most efficient solution. This ensures fairness among investors, simplifies negotiations, and maintains the attractiveness of the investment opportunity for future financing rounds.