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The Ultimate Guide to Liquidation Preferences

Whether you are a venture investor or entrepreneur, you’ve most likely heard the the term “liquidation preference”. If you did not know too much about it, you probably searched up a definition on Investopedia or read a few blog posts to familiarize yourself. While those pieces may be a good start, I was shocked to find a lack of in-depth material on the topic given that liquidation preferences are important to any term sheet and returns analysis. The purpose of this post is to provide a detailed guide for both investors and entrepreneurs that breaks down the different types of liquidation preferences and its effects on payout structures.

What is a liquidation preference?

A liquidation preference is a provision meant to serve as protection for investors if a company exits at a value lower than what was initially expected.

To illustrate how it works, let us look at its legal language:

In the event of any Liquidation Event, either voluntary or involuntary, the holders of each series of Preferred Stock shall be entitled to receive out of the proceeds or assets of this corporation available for distribution to its stockholders (the “Proceeds”), prior and in preference to any distribution of the Proceeds to the holders of Common Stock…

A liquidation preference is designed so that preferred shareholders (the investors) receive their money back before any of the common shareholders (employees and founders). Before we dive into details, it is important to understand its use cases and limits. Liquidation preferences are only attached to preferred shares which are typically issued to investors during financing rounds. In this sense, a liquidation preference is ONLY important when a company exits via M&A or sells off its assets during bankruptcy/recapitalization. A liquidation preference is not relevant to public exits because an IPO typically auto-converts all preferred shareholders into common shareholders.

There are four primary features of a liquidation preference:

The multiple determines the amount an investor must be paid back before the common shareholders start receiving any remaining proceeds. A 1x liquidation preference means that if you (as a venture capitalist) have invested $1 million (M) into a company, you must be paid back $1M before any common shareholders are paid anything. If the company was sold for $1.5M, you would be guaranteed at least $1M no mater what your equity ownership is. If this company was sold for $900,000, you would be guaranteed the entire proceeds because $900,000 falls under your guaranteed $1M in liquidation preference. For a 2x multiple, you will be paid back $2M (despite only committing $1M) before common shareholders are paid anything. Multiples are typically 1–2x but depending on market conditions, they can be as high as 10x. If you are an entrepreneur, you obviously want the lowest possible multiple to have the least amount of proceeds obligated to the investor.

2. Participating vs. Non-Participating

Non-Participating Liquidation Preference: Under this type, the investor has the option to either 1) exercise his/her liquidation preference or 2) convert their preferred shares into common equivalent shares (where equity ownership % is derived) and be paid a proportion of the proceeds based on their equity ownership of the company. Typical preferred to common conversion rates are 1 to 1 but one should read terms carefully to avoid getting blindsided by a higher/lower conversion rate.

To illustrate the non-participating type, if you have invested $1M into a company with a 1x non-participating liquidation preference in exchange for 20% ownership, and the company was sold for $2M, you will have two payout options. You can exercise your liquidation preference to receive a guaranteed $1M back, or you can choose to convert your preferred shares for $400,000 (20% of $2M). The rational choice would be to obviously exercise the liquidation preference for the higher payout ($1M>$400,000). In this specific example, an exit value of $5M must be achieved for the investor to be indifferent between choosing to exercise or convert since the same payout ($1M) would be achieved under both choices. This point of indifference is called the conversion threshold. An exit value below the conversion threshold would force an investor to exercise his/her liquidation preference. An exit value above the conversion threshold justifies conversion into common equity.

Participating Liquidation Preference: Unlike non-participating, for participating, when the investor has been paid back his/her liquidation preference, they will receive additional “ participation” in the remaining proceeds in proportion to their ownership. Let’s say you have invested $1M into a company with a 1x participating liquidation preference in exchange for 20% ownership. If the company was sold for $2M, you would be guaranteed $1M, and then an additional 20% of the remaining proceeds. 20% of the remaining $1M would equate to an additional $200,000 payout, generating a total payout of $1.2M.

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Think of participation as double-dipping into the proceeds pool. Participating preferred holders will never convert because they will always have a higher value/share than common shareholders since they are adding their guaranteed liquidation preference value on top of participation (which is the same value as common shares). Founders should avoid participating liquidation preferences as this will always generate a larger exit value for the investor (thus, smaller for the founder) than non-participating liquidation preferences. Participating is less common than non-participating liquidation preferences.

While liquidation preferences were designed to protect investors, participating liquidation preferences can create unfair scenarios for the entrepreneur. Caps on the amount of committed capital were introduced to protect the entrepreneur. These days, payout caps are typically around 3x the investment amount. An investor committing $1M with 1x participating liquidation preference on a 3x cap will receive up to $3M in total proceeds ($1M liquidation preference + $2M in participation) if he/she does not convert. An investor must choose to convert fully to common to receive any payout higher than its cap. Thus, the cap introduces a conversion threshold for participating preferred shareholders that otherwise would not exist. Below is a waterfall visual of MDx Medical’s (Vitals) 4-tiered, participating liquidation preference with a 3x cap on all investors with the exception of investors in the Series D round. Note that the Series D preferred shareholders will always have a higher price/share value than the common shareholder due to having an uncapped participating liquidation preference. As you can observe, having no cap on participation has an adverse effect on the entrepreneur.

The Ultimate Guide to ACH Payments

Paper checks and wire transfers have their drawbacks. From high transaction costs to slow processing times (for paper checks), these payment methods boast numerous inconveniences. ACH payments, on the other hand, have become a preferred choice among businesses looking to lower payment processing fees and streamline their vendor payment processes.

In 2020, nearly eight percent of all ACH network transactions were issued for government-related payments. The remaining 92.1% were issued for commercial purposes, such as businesses accepting payments from customers via the Internet, through digital check scanners, and as recurring monthly payments for utility bills.

In 2020, the Automated Clearing House processed an astonishing 21.5 billion ACH transactions. The amount of money transferred between bank accounts was more than $46.8 trillion. Compared to the prior year, there was a 5.7% increase in the number of transactions and a 6.9% rise in the total dollar amount. This makes for the third year in a row that the volume of ACH transactions have risen by at least one billion.

Want to learn more about ACH payment processing? We’ve put together the ULTIMATE guide to ACH payments. Throughout the content, you will find links to other articles that provide a more in-depth look at the topic being discussed.

What Is the Meaning of ACH Payments?

The ACH payment system was created as a way to reduce the number of paper checks that were used to pay for goods and services. The ACH network allows businesses to accept funds from customers using an electronic format. The funds are debited from a customer’s account and credited to the business’ account. You have likely heard of ACH payments being referred to as “e-checks.”

One of the most common uses of ACH payments can be seen among businesses that electronically deposit funds into the accounts of their vendors and suppliers. Some take advantage of ACH payment processing by having utility payments automatically deducted from their checking accounts. Over the past few years, ACH payments have become increasingly popular for business-to-business electronic monetary transfers.

Want a more thorough explanation of the meaning of ACH payments? Check out our in-depth guide on ACH payment meaning.

How Do ACH Payments Work?

Even though the ACH payment process is rather simple, there are many entities involved. The exact process that takes place will depend on whether an ACH debit or credit transaction is being initiated. Here’s an easy-to-understand explanation of both processes.

When you initiate an ACH debit transaction, you’ll need to make sure you have connected your bank account to the ACH network. You will give permission for the Receiving Depository Financial Institution (RDFI) to debit (deduct) funds from your account to pay for a good or service. The Original Depository Financial Institution (ODFI) will send a batch of debit entries to the ACH network, with one of those requests being to debit your account. Your bank, the ODFI, will approve the entry and send the payment to the RDFI. During the time that it takes to process the transaction, you will see a “pending ACH transfer” on your account.

When you initiate an ACH credit transaction, you are providing permission for monies to be credited to your account. For example: You start working for a new employer and you are asked to fill out an ACH permission form to verify that it is okay for your paycheck to be deposited directly into your checking account. Your employer’s ACH processor will actually be the one who initiates the transfer of funds. In this type of transaction, the employer’s bank account is the ODFI and your checking account is the RDFI.

What Is NACHA?

NACHA is an abbreviation for the National Clearinghouse Association, which is an entity that is responsible for making sure consumers and businesses are fully aware of how ACH payment processing works. NACHA strives to ensure everyone is provided with educational resources and tools that not only show them how ACH payments work, but that enhance the safety and speed up the processing of the payments.

ACH Rules You Need to Know

There is a long list of rules and regulations that businesses should be aware of regarding ACH payments. When businesses do not comply with these rules, there are massive fines that can be enforced. It can also lead to ACH payments being voided, which translates into businesses ACH payments being voided. Here’s a look at several ACH payment rules businesses should know.

Businesses Must Verify Their Account Information

You should regularly check your business’ account information on ACH payment forms to ensure it is correct. You can take advantage of the ACH validation test tool to check account information. This test requires you to send a negative transaction to your bank to make sure your business’ account information is correct. You can also use a third-party validation tool. If preferred, you can issue micro-deposits or use a customer sign-in tool to check account information.

The purpose of micro-deposits is to ensure the payer is the owner of the provided account information. The micro-deposit workflow involves providing your bank account and routing number. You may have to provide the name of your bank as well. An ACH operator can send a request to the Automated Clearing House for micro-deposits to be deposited into your account. Once you verify them, the funds will then be deducted. Micro-deposits usually range anywhere from one to 50 cents.

Get NACHA Certification

When you obtain NACHA certification, you are showing customers that you value their business and privacy. Whether you are accepting ACH payments from customers or conducting business-to-business ACH payments, this certification highlights your commitment to payment security.

NACHA certification is for businesses who act as a third party for processing ACH payments. You should look for an ACH operator with NACHA certification, or if you are this third-party, you should obtain it. In order to acquire the certification, you must have a company background check performed. Additionally, you’ll have to prove your compliance with NACHA ACH rules and any applicable risk management guidelines.

Same-Day ACH Payment Rules

In 2020, NACHA made same-day debit ACH payment processing available. This method of electronic payment has been a huge success and has significantly increased in popularity. At the end of the second quarter of 2020, the use of same-day ACH payments had risen by 243% over the previous year.

Updated rules that will apply to same-day ACH payments include (these rules are expected to go into effect during 2020 and 2020):

  • New rule gives businesses an additional two hours to submit same-day ACH payments.
  • New rule will provide a $100,000 cap on same-day transactions; under the current rule, the cap is $25,000. This will considerably help businesses process same-day ACH transactions.
  • New rule will allow receivers to access the funds at 1:00 p.m. local time as long as the payment was processed in the morning.

How to Set up ACH Payment Processing

As a business owner, you should do all you can to increase revenue and decrease expenses. Since payments are at the core of your success, you should take measures to reduce transaction costs, and it starts with making ACH payments. Check out these six tips for setting up ACH payments, or keep reading below for a brief overview of setting up and accepting ACH payments.

Can Your Brand Benefit From Making ACH Payments?

Almost all brands will benefit from making ACH payments. The low transaction cost makes these payments incredibly favorable when compared to credit and debit card processing. ACH payment processing is particularly advantageous for brands that make payments on a recurring basis.

For example, a company that has a high number of suppliers will find it beneficial to make ACH payments. This company can enjoy low transaction fees on each payment made, and it’s also possible to set the payments up on a recurring basis. Instead of having to issue the payment to a supplier each month, the funds can be automatically deducted from the payer’s account.

Choose an ACH Merchant

The next step in making ACH payments is to speak with your bank to see if they are an ACH merchant provider. If not, you will need to compare transaction fees among three or four merchants and choose one that can best meet your needs. It’s pertinent to choose a merchant with NACHA certification.

Make sure to evaluate the level of support provided by each ACH merchant provider. Does the provider offer invoice automation? Can the ACH payment processing be integrated with your accounts payable software? What type of security does the provider offer surrounding ACH processing? How does the service offered make your backend processes more efficient?

When you’re choosing an ACH merchant, this is the entity that is going to serve as your ODFI. It will also be the entity to which you send debit entries. The ODFI will, in turn, send the entries to the Automated Clearing House or the Federal Reserve (another entity that clears ACH payments). Once processed, the funds will be debited from your account and sent to the appropriate RDFIs. This applies if you are paying your employees. If you are receiving payments from customers, the ACH merchant will act as the RDFI.

Onboarding

You will go through an onboarding process when you first team up with an ACH operator. It will likely be carried out through a secure online portal. The onboarding process is usually referred to as the corporate enrollment process.

The onboarding process covers a range of topics, including how to enter vendor account information, how to initiate transactions, and how to set up recurring debit transactions. You’ll learn how to bring payments and remittance together to streamline your vendor payment process.

It is a unique transformation that takes place when you start making ACH payments, and an ACH operator can guide you through the entire process.

Acquiring Permission

No matter the type of ACH payment being processed — debit or credit — permission from both parties must be provided. It is always a good idea to collect and store permissions in an electronic format. This way if you ever need to dispute a charge, you can easily locate the applicable permissions that were given.

When giving permission, check to ensure the vendor’s account information is correct, along with your account information. You don’t want your funds being deposited into someone else’s account because you entered the account information incorrectly.

Take Advantage of Your Operator’s Portal

After you have finished the onboarding process, you can access your operator’s portal to proactively view payment status updates, view rejected payments, re-issue payments, and more.

Depending on your operator, you may be able to use the online portal to produce reports and visual charts that give you a clear overview of where your payments are going. This allows you to refine your budget.

Furthermore, you can pinpoint vendors that provide early payment discounts and then adjust your payment dates to ensure you take advantage of these discounts.

Enjoy ACH Payments

Once you give the paperwork to your bank or ACH merchant, the information will be submitted and the payment process will begin according to the date and time you provided. Keep in mind that it generally takes anywhere from two to five days for the ACH payment process to complete. You can expect to see funds deducted from your account within 24 hours if you have set up a same-day ACH payment.

How Long Does an ACH Payment Take to Process?

ACH payments definitely have their advantages, particularly for businesses because they come with low transaction fees. However, the time that it takes for the transaction to complete can sometimes be a downside. It also presents a problem in that an ACH payment can lead to costly overdraft charges.

Compared to debit and credit card transactions, ACH payments take considerably longer. If all three types of payment transactions are conducted electronically, why is there such a difference in the time that it takes to process an ACH transaction? Here’s a detailed answer to that question.

First of all, there are numerous entities involved in an ACH payment process. A vendor’s payment processor (RDFI) will collect necessary payment data from the payer and send it to the customers’ bank (ODFI). The ODFI, in turn, will send the entry request to the Automated Clearing House, alerting it to release the funds to the RDFI. Many times, the processing takes anywhere from two to three days and the settling of the transaction does not occur until the fourth day.

The lengthy process of ACH transactionsoften stems from risk management. Unlike credit and debit transactions that take place immediately, a customer can dispute an ACH transaction during the three days that it takes to process, thus preventing the RDFI from receiving the funds.

When making ACH payments, you will not be alerted when the transaction has completed. You can log into the ACH operator’s web portal to see which transactions have completed. To ensure a payer isn’t going to reverse the payment, the ODFI will often prolong the settlement process.

Another factor that impacts the long processing time of ACH payments is their processing in batches. A merchant will not submit an ACH payment one at a time. Instead, it will send batches to the Automated Clearing House or Federal Reserve anywhere from one to three times a day. To be processed overnight, the payments must be received by a certain time. When batches are sent after the cutoff time on Friday, they are not looked at again until the following business day, which will normally be Monday, unless it is a holiday.

Any time there is an error in the data, this will delay the processing time. For example: You send your account and routing information to the receiving entity, and due to human error, it is entered incorrectly into a virtual terminal that processes ACH payments. If this was to happen, the Automated Clearing House or Federal Reserve would reverse the transaction. The ODFI checks to see if any of its initiated transactions have been reversed. It will also check for return codes to get a thorough understanding of why the transaction did not go through.

A Close Look at ACH Payments and Wire Transfers

Sending money electronically is a safe and secure method, especially when compared to sending cash through the mail. Electronic payments come with automated record keeping and are easy to track. Wire transfers are often confused with ACH payments. Both have their pros and cons.

A wire transfer is costly but moves money in less than 24 hours from one bank account to another. When time is of the essence, it is important to initiate a wire transfer in the morning to ensure it is received by the RDFI before the end of the day.

An ACH payment is going to take two to five days to process. A key difference between ACH payments and wire transfers is that the latter cannot be initiated unless the funds are in the sender’s account. An ACH payment can be initiated regardless, but it will not clear if the funds are not available.

It’s also important to note that a wire transfer cannot typically be reversed; this is why it is imperative to ensure you have provided the recipient’s true account details. An ACH payment, on the other hand, can be disputed and reversed. For example: A vendor receives a direct deposit ACH payment, but you accidentally overpaid. In this type of instance, the overpaid funds could be refunded to you.

Voiding and Refunding ACH Payments

It’s usually simple to void or refund ACH payments. You will need to provide a reason as to why the transaction should be voided, and if it qualifies as a valid reason, the transaction will be stopped. For example: A payer has set up recurring payments to pay for a utility bill. The payer decides he or she no longer wants the funds to be automatically deducted from his or her account and contacts the ACH operator to stop the transfer

How Much Does It Cost to Process an ACH Payment?

Making ACH payments is a smart business move. Compared to processing debit and credit card transactions, ACH payments are very cost-efficient. Most ACH processors will charge a flat rate ranging from 25 cents to $5 for each transaction. Some processors charge a percentage of the transaction, but unless your average transaction is below $2.50, it is usually best to opt for a processor that charges a flat rate.

Conclusion

Choosing the right ACH payment processor is vital to business success. With the wrong services provider, you will hinder supplier and vendor relationships due to limits and restrictions on the number of ACH transactions you can process in any given month. This can make it incredibly difficult to pay your vendors and suppliers on time.

Small banks often fail to have the necessary technology and resources that it takes to handle large volumes of ACH transactions. Their fees are typically high, which can quickly eat away at your profits.

To learn more about how ACH payment processing works, download our PDF package that’s full of valuable information.

Binary Options

What are binary options

A binary option is a type of option with a fixed payout in which you predict the outcome from two possible results. If your prediction is correct, you receive the agreed payout. If not, you lose your initial stake, and nothing more. It’s called ‘binary’ because there can be only two outcomes – win or lose.

Advantages of binary options trading

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