If a company succeeds there are a number of ways that investors can see their money repaid, recouping their capital plus any gains that have been made over time.
However, not every company succeeds.
It’s smart preparation for companies to consider potential exit strategies. It would be through one of these exit plans that, if a company doesn’t succeed, any potential liquidity will materialize.
Methods of Repaying Investors
Investors typically get repaid when they sell their shares in return for cash. There are several potential scenarios:
- The company gets bought by another in a merger or acquisition. Hopefully, the shares are purchased at a premium, giving the investor a return on their initial investment as their shares have increased in value
- The investor sells their shares to a third party – either another investor or a specialist firm. These are private transactions and don’t take place on an exchange. The investor may get more for their shares than they initially paid, or they may take a loss
- The company places its shares on the open market via an Initial Private Offering, or IPO. The existing investors trade their shares for public shares or cash out
- The company offers to repurchase existing shares from investors at a negotiated price. The investors can therefore potentially sell at a premium at the original price, thus realizing a return on their investment
Naturally, these are not the only ways that investors can benefit from their investment. A trading company may also pay dividends to investors, although these are at the company’s discretion and it can take many years for investors to recoup their initial investment. For example, Facebook only began paying dividends in 2024.
Understanding the Waterfall
A distribution waterfall is how funds are distributed among different classes of debt and equity in a company. It operates like a waterfall in nature, with higher priority participants (normally debtors) being paid in full first, with lower ranking participants (normally shareholders) only being paid once the debtors have been satisfied in full.
In a liquidation scenario, the waterfall determines the order in which founders and shareholders get paid if funds remain after debt has been paid. For example, there may be a carve-out for all shareholders pro rata, followed by a distribution to holders of preferred shares, followed by a distribution of what’s left to ordinary shareholders.
Determining seniority between equity holders is a function performed by liquidity preferences. These preferences are an absolutely key instrument in these waterfalls. Preferred shareholders often have liquidity preferences that give them priority over common shareholders, making sure that they receive their initial payment back, plus accrued dividends before those common shareholders get paid. In a liquidation event, these preferences can have significant impacts on the financial outcomes for all equity holders.
Advice for Investors
Whether you’re a newbie or a seasoned investor, you’ll want to be confident that your portfolio is secure. The best way to accomplish this is to spread your risk. Diversify your investments, either geographically, thematically or numerically, so that your portfolio is balanced.
A second obvious way to protect your investment is to do your diligence. Read the financial statement, talk to your peers and conduct desktop research on the company before investing.
It’s crucial you take the time to understand what it is you’re signing. Make sure you’re across all of your rights and those of the other investors. The terms of the investment agreements that you and the other investors sign, including preferential rights or liquidation preferences, could have far-reaching implications when it comes to your exit and financial outcomes.
Finally, understand that returns on investment can take time. Don’t expect to make money quickly and invest over the longer term (5-10 years). And don’t hesitate to cash out if you sense that the company is in trouble.
Conclusion
So, as discussed, when you’re investing, exit strategies should be one of the first considerations, as this is where your liquidity will emerge. Think about what exit options the company can offer to you.
But it’s equally as important, before you sign, to have full comprehension of your own rights and liquidation preferences as well as those of other investors. This is how you can figure out exactly where you stand in the waterfall respective of the others, and determine whether it’s worth it for you to get involved.
If a business has too much debt, cash flow issues, or is losing money, the investors repayment may be diluted. Getting out early is often better than waiting until the company runs into serious trouble and is liquidated.
From the investor’s perspective, the best protection against these scenarios is ensuring they have a diverse portfolio of investments and a robust exit plan, including built-in anti-dilution provisions.
References
[1] https://equitymatch.co/newsbrief/the-end-of-the-road-exit-strategies-for-startup-investors
[2] https://www.jamescole.co/blog/how-do-investors-get-paid-back
[3] https://www.joinarc.com/guides/pro-rata-rights
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