In our last post, we discussed investment scenarios with only a single investor. However, in reality, most companies have multiple investors investing in multiple financing rounds. In such a case, determining liquidation waterfall becomes extremely challenging. With multiple investors in play, a new clause enters the term sheets – “Seniority”

Simply put, seniority is the preference order in which investors get their money back. Also, the seniority ranking is usually allotted to share classes and not individual investors. For instance, Series B would get a seniority ranking of 3 and Series A would get a seniority ranking of 2. Common shareholders usually have the lowest seniority ranking of 1.

Higher the Seniority ranking, Higher the preference in liquidation waterfall.

 

Usually seniority preferences flow downward. That is, later investors get higher preference. So, Series B are paid back their dues before Series A investors receive their share of the pie and so on.

Let us assume that FW raises Series B, with VC firm ISA Ventures investing $5m for 37.5% stake in FW. The updated captable would look like this.

Investor Share Class Investment (in USD) Fully Diluted Stake
ISA Series B $ 5,000,000 37.5%
MPG Series A $ 3,000,000 25%
Founder Common $ 10,000 37.5%

 

The share class details would be as follows

Share Class Liquidation Preference Preferred Participation Participation Cap Cap Multiple Seniority
Series B 1x Yes Yes 2x 3
Series A 1x Yes Yes 2x 2
Common No No N/A 1

 

In case of an liquidation event, first the Series B shareholders would be paid back followed by Series A shareholders followed by common shareholders

Seniority

FIGURE 1

As seen in figure 1, till a value of $5m only Series B shareholders are paid back. After that Series A shareholders join in. Common shareholders join in the last – at an exit value of $9.8m

Sometimes, this structure might be reversed – later investors might be paid after early investors. Series A would be paid back before Series B. This structure is not very prominent and rarely practiced.

Finally, seniority might be pari passuInvestors across all stages have the same seniority status. In this situation both Series A and Series B would have same preferential rights over exit proceeds.

Pari Passu

FIGURE 2

Here, both Series A and Series B start sharing proceeds at the beginning itself. Initially, as the exit proceeds are insufficient to cover liquidation preferences of both Series A and Series B, exit proceeds are shared in proportion of amount invested till $8m, at which point the exit proceeds are sufficient to cover liquidation preferences of both the share classes. Common shareholders join at an exit value of $8m after which the proceeds are shared on a proportionate basis of the FD stake.

Finally, there might also be a hybrid of pari-passu and usual seniority – i.e some classes might be pari passu within themselves but senior to other classes. Let’s take a hypothetical example.

Share Class Liquidation Preference Preferred Participation Participation Cap Cap Multiple Seniority
Series E 1x Yes No N/A 4
Series D 1x Yes Yes 3x 3
Series C 1x Yes Yes 3x 3
Series B 1x Yes Yes 2x 2
Series A 1x Yes Yes 2x 2
Common No No N/A 1

 

Here, Series E holds the highest seniority among all classes. Series E shareholders would take their share of the proceeds before other shareholders can take their share. After that shareholders of Series B, C and D would take their proceeds on a proportionate basis. Thus, Series C is senior to Series A but equivalent to Series B and Series D in terms of seniority.

Clearly, seniority makes a lot of difference, especially if the exit value of the company is not high as expected. Senior classes will take the lion’s share of the proceeds and leave nothing on the table for junior classes. That said, seniority makes little difference if the exit value is really high and comfortably covers all liquidation preferences and preferred participation. Also, in case of an IPO, all the preference shares usually convert into common shares automatically, eliminating all the liquidation preferences.

Gap in expected proceeds and actual proceeds increases as more and more financing rounds happen due to stacking up of seniority levels and liquidation preferences of late investors. You might expect 30% of the proceeds due to holding 30% of shares but in reality, receive a much lower percentage due to liquidation preferences of later investors.

 

The best way to minimize this gap is to know beforehand the impact of future investors’ liquidation preferences and seniority are going to have on your returns and use this knowledge to negotiate accordingly.

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