Why a Founder Could End up Empty-Handed After an Exit (Or "What Is Liquidation Preference?"​)

Did you know that you could end up empty-handed after the exit of your successful startup?

Even though you‘re the founder(s). The one(s) who built it from the ground up. Who sacrificed and invested blood, sweat, and tears?

I found this gold nugget in the Swisspreneur episode #29 with Christian Meisser, in which he gives a great overview of the legal fundamentals you need to handle. You can listen to the full episode here.

Naturally, there is a lot of paperwork involved when taking on an investor. After all, a lot of money is changing hands and the investor has a high risk of losing said money.

Within these contracts, there a „Liquidation Preference“ clause for which many investors will want a „1x“ status. This means that when you sell your company, the profit is not distributed evenly by shares, but the investment sum is returned to the investor first, and the rest is split up afterward.

The liquidation preference determines who gets their money first when a company is sold, and how much money they are entitled to get.

So if you got a 1M investment and sold for 1.2M, 1M is returned to the investor and you are splitting the 200k among the founders and remaining stakeholders.

That‘s not a favorable outcome for the founder(s) and other stakeholders. But it makes sense from an investor's perspective.

I believe having a fair and balanced contract which protects the investor, founder(s), and of course, the interests of the company is essential. The basis for this contract is transparency regarding your wants and needs, communicating intensely with your investor, and managing and aligning your expectations is fundamental.

(P.S: Please seek legal assistance if you are unsure about your contracts and documents)

Inspired by: Swisspreneur EP #29 - Christian Meisser: Legal Advice For Early Stage Startups and Christian Meisser