The Ultimate Guide to Liquidation Preferences

If you're an entrepreneur or a VC investor, chances are you've come across the term "liquidation preference".

Maybe you already read some articles about it and noticed that the amount of in-depth material on the topic is inversely proportional to its importance.

What’s a Liquidation Preference?

A provision intended to protect investors if a company exits at a lower value than originally expected. Which is mostly the case as you may know (see chart below).

Let's take a look at the legal language:

Or in easy words: Preferred shareholders receive their money back before any of the Common shareholders.

Preferred Shares vs. Common Shares

1. Both types of shares grant the holder partial ownership rights ofthe company. However, investors typically negotiate for preferred shares, while founders and employees usually receive common shares.Liquidation preferences are only attached to preferred shares!Quick Summary:

   1. Common shares for founders & employees

   2. Preferred shares for investors

   3. Preferred shares come with certain benefits incl. liquidation preferences

Features of a liquidation preference

1. The Multiple

Determines the amount an investor must be paid back before common shareholders receive any remaining proceeds.Example: → Investor invests $1M at a 1x liquidation preference.

→ In a liquidation event, they will receive $1M back (= 1x their investment) before common shareholders receive anything.If the company gets sold for <$1M, they'll get everything. If it gets sold for >$1M, they would be guaranteed at least $1M no matter what.Sometimes, you'll see 2x or even 3x liquidation preferences as shown below.

That's pretty nasty!

With a 3x liquidation preference, the investor in our previous example would be paid back $3M – 3x invested capital – before common shareholders are paid anything.Typically, it's between 1–2x depending on market conditions.

2. Non-Participating vs. Participating

Non-participating:

Investor can either 1.) exercise liquidation preference OR 2.) convert preferred shares into common shares.

Participating:

Investor 1.) will get paid back liquidation preference AND 2.) will receive additional “participation” in the remaining proceeds proportional to their ownership.Small but important difference!

Let's take our previous example:Now the company gets sold for $2M.

• $1M investment with

• 1x liquidation preference

• and assume 20% ownership.

Now the company gets sold for $2M.With a non-participating liquidation preference, the investor has 2 options:→ Exercise liquidation preference and get $1M back.OR→ Convert preferred shares into common shares for $400k (20% of $2M)Pretty sure they'd pick option 1.What if the company gets sold for $5M?→ Exercise liquidation preference and get $1M back.OR→ Convert shares for $1M (20% of $5M)You see? Now they would get the same amount with both options!This point is called Conversion Threshold.As an investor, of course, you always choose the option that earns you more.Now we look at the participating liquidation preference!Same situation:→ $1M investment→ 1x liquidation preference→ 20% ownership→ Company gets sold for $2MWhat happens now?→ Investor exercises liquidation preference and gets $1M back.AND→ Additional "participation" in the remaining proceeds ($1M) according to 20% ownership (=$200k).

Non-participating = $1M vs. Participating = $1.2M

Or in easy words:

• Non participating: "Choose the best option that brings you the most."

• Participating: "Double-dipping into the proceeds pool."

Conclusion: Founders should try to avoid participating liquidation preferences!

3. The Cap

While we were talking a lot about protection of investors, this is about protecting founders!

The cap is a conversion threshold for investors with participating liquidation preferences.

After exercising their liquidation preference, they may only participate in the remaining proceeds until the cap is reached.

Payout caps are typically around 3x the invested amount.

You remember our example?→ $1M investment with a 1x participating liquidation preferenceAssuming a 3x cap, this will lead to up to $3M in total proceeds:

• $1M by exercising liquidation preference,

• $2M in participation.

Note: Participating investors with a cap will usually still be able to fully participate – without a cap – alongside common shareholders if they waive their liquidation preference and convert all their preferred shares into common shares.

4. Seniority Structures

Typical payout structures are a bit more complicated than shown in the previous examples as there are different seniority levels for liquidation preferences.

They determine where investors stand in the payout order.

Standard Seniority (most common)

Liquidation preference payouts are done in reverse order from latest round to the earliest round.

Pari passu

Investors across all stages have the same seniority status.

Tiered Seniority

Investors from different rounds are being grouped up into tiered seniority levels.

I hope this has given you some good insight!✌️