Liquidation Preference: What Investors Get First

1-sentence takeaway: A liquidation preference determines which investors get paid back first, and how much, if a company is sold or liquidates its assets. It’s a form of downside protection, primarily for preferred stockholders.

Think of it like a line at a buffet. Preferred stockholders, because they took on more risk early on, get to cut in line ahead of common stockholders (founders, employees, etc.) when the “food” (money from a sale) is being served.

What is it?

A liquidation preference is a clause in a company’s term sheet that dictates the payout order in a liquidity event like an acquisition, merger, or IPO. It essentially guarantees a certain return to preferred stockholders before common stockholders receive anything. This helps mitigate the risk for early investors.

How does it work?

Liquidation preferences are typically expressed as a multiple of the original investment. For example, a “1x liquidation preference” means an investor gets their initial investment back first. A “2x liquidation preference” means they get twice their initial investment back before common stockholders see a dime.

Example:

Imagine Company X is sold for $20 million. A Series A investor put in $5 million with a 1x liquidation preference. That investor gets $5 million back first. The remaining $15 million is then distributed to other stakeholders according to their share ownership.

Different types of liquidation preferences:

• Participating Preferred: After receiving their preference, these investors also participate in the distribution of the remaining proceeds alongside common stockholders. They get their cake and eat it too, so to speak. This can significantly reduce what’s left for common stockholders.
• Non-Participating Preferred: These investors choose either their liquidation preference or to convert their shares to common stock and share pro-rata with everyone else based on ownership percentage. They pick whichever option results in a greater return.
• Capped Participating Preferred: This is a hybrid approach. Participating preferred investors receive their guaranteed multiple and share in the remaining proceeds, but only up to a specified cap (e.g., 3x their initial investment). This balances the interests of preferred and common stockholders.

Why is it important?

• For investors: Liquidation preferences offer downside protection, increasing the likelihood of recouping their investment if the company doesn’t perform as expected.
• For founders/employees: While it may seem like liquidation preferences disadvantage common stockholders, they are a necessary tool for attracting early-stage investment. This investment fuels growth, ultimately benefiting everyone if the company succeeds.

Things to consider:

• The specific terms of a liquidation preference can vary significantly.
• Multiple rounds of funding can lead to complex “stacking” of liquidation preferences where earlier investors get paid before later investors. This can further dilute the returns for common stockholders.

Learn more:

• Preferred Stock
• Common Stock vs Preferred Stock Key Differences
• The Cap Table Capitalization Table Who Owns What

So here’s what we covered:

• Definition of liquidation preference
• How it works in a sale or liquidation event
• Different types of liquidation preferences (participating, non-participating, capped participating)
• Why it’s important for both investors and founders/employees
• Additional considerations and further learning resources