Demystifying Term Sheets: Part 3 - Liquidation Preference

Negotiating a term sheet can feel like walking a tightrope, a delicate balance between ambition and protection for both entrepreneurs and investors. Every line of a term sheet carries weight, telling a story about the future of a business. Drawing from years of experience in the VC play, we are pulling back the curtain to highlight what really matters in a term sheet, how both sides should approach it, and the lessons we have learned (sometimes the hard way) to avoid common pitfalls.

In the spirit of transparency, we are sharing a copy of our full term sheet template here.

This article is meant to serve as a guide to navigating term sheet negotiations, highlighting the most critical clauses, and sharing tips for both entrepreneurs and investors. Our term sheet reflects how we do things differently. When our founders Gonzalo Martínez de Azagra and Igor de la Sota set up the fund, they did not just replicate existing VC practices, they built something that truly represents Cardumen Capital’s values.

That said, this guide is not set in stone; it is a living document that evolves as the market changes. But before diving into the details, here is an important starting point: a term sheet is not a promise to invest, in other words, it is not a legally binding document. Even when signed, it is not a guarantee of funding. Instead, it should be seen more as an agreement to keep negotiations private and, in some cases, to pause the company from exploring other offers for a certain period of time.

Now, let us get down to business. While every term sheet is unique, just like every investment offer, there are certain key terms that almost always come up in negotiations. Keep reading to learn what these are and why they matter.

In our previous articles of this series, we covered valuation (Part 1) and ESOP (Part 2). In this artcicle, we turn our focus to liquidation preferences—one of the most critical (and often misunderstood) terms in venture deals.

Distribution Preference

Liquidation preference dictates how the proceeds from a company exit (i.e. a sale or liquidation) are distributed among shareholders. It is a crucial term that can affect the payout dynamics between founders, investors, and other stakeholders.

The Basics

There are two components that make up what most people call the liquidation preference: the actual preference and participation.

Preference:

• A 1x preference ensures investors get back what they invested without creating undue burden on founders.
• Preferences above 1x (i.e. 2x) are rare these days but may appear in later-stage or high-risk investments where the investor requires more downside protection.

Participation:

• Non-participating liquidation preference: The investor chooses between receiving their preference (i.e. 1x their investment) or participating in the distribution as a common shareholder. This structure is standard and is generally more favourable for founders because it limits the investor's total claim.
• Participating liquidation preference: The investor gets their preference amount and shares in the remaining proceeds proportionally. This structure can significantly dilute founder payouts, but it is sometimes capped to make it more balanced.

Complications and Nuances

Senior vs. Pari Passu Preferences:

• Senior preferences give certain investors priority in recovering their funds, potentially leaving less for other investors or founders.
• Pari passu, where all preferred shareholders are treated equally, simplifies distributions and is generally viewed as fairer.

Key Takeaways

Cardumen Insight

‍In general, a 1x liquidation preference is perfectly reasonable. Our recommendation for entrepreneurs and our co-investors: keep it simple and lightweight in early rounds.