Recently an entrepreneur asked me what the current market was for liquidity preferences and dividends for institutional investors funding startups in the region. As a background, liquidity preferences are a provision investors often ask for as part of a preferred security that guarantees them some amount of money before other shareholders receive any money in the event of a sale.
Within the concept of liquidity preferences there are non-participating preferred and participating preferred. Non-participating preferred means that the investor gets some amount of money back first (usually the amount invested) and if the amount of the sale is large enough, then everyone participates based on their percent ownership. So, if an investor invests $1 million and has a 1x non-participating preferred equity and owns 25%, if the company sells for at least $4 million, then everyone gets paid based on the percent of the company they own. If the company sells for less than $4 million, the investor gets their $1 million back first and the remaining amount of money is split amongst the other shareholders based on the percent they own.
Participating preferred is where the investor gets some amount of return on their investment (usually the amount invested) and gets the percent ownership of the remaining amount of the proceeds regardless of the amount of money. These types of investments effectively reduce the valuation of the company by the amount of the participating preferred investment. So, if a company raises $1 million with a 1x participating preferred investment at a $3 million pre-money valuation, the valuation is effectively $2 million pre-money due to the participating preferred equity. If the company sells for $4 million, and the investor owns 25%, the investor gets $1 million plus 25% of the remaining $3 million, which equals $750,000, for a total of $1,750,000. You can see that 25% ownership of a $4 million exit doesn’t normally equal $1,750,000 unless they have this type of provision.
Dividends are typically in the form of cumulative and non-cumulative with the difference being if the dividends compound every year or stays fixed based on the original investment. With a $1 million investment and non-cumulative dividends of 8%, the effective amount owed for the dividends goes to $80,000 per year. With a $1 million investment and cumulative dividends of 8%, the effective amount owed goes to $80,000 in year one, $86,400 in year two, $89,000 in year three, etc.
The current market for the region is a 1x participating-preferred liquidity preference with an 8% cumulative dividend. On a simple level this means investors are offering valuations higher than might be expected for entrepreneurs with a tradeoff of serious downside protection in the event the investment doesn’t do well. Again, this is more for institutional investors and not as typical with angel investors and seed rounds.
What else? What are some other thoughts on the current market for liquidity preferences and dividends?