A liquidation preference deals with what happens to the proceeds of the Company after it is dissolved or sold. Investors typically want to get their money back first before anyone else and a liquidation preference outlines that right. There are several types of liquidation preferences.
Standard Seniority
This is present in most financings. It means that investor gets the first proceeds from any sale of the Company. Typically, founders and employees have Common Stock which means they will usually share in the proceeds relative to their ownership (called pro rata) and anyone with Preferred Stock will be paid before the Common stockholders. Investors may also have a liquidation preference even if they have Common Stock but we would still consider this a liquidation preference because the investor gets paid first.
Pari Passu
This means that all of the defined stockholders are paid at the same time. There is a potential issue with this if there are not enough proceeds to give everyone their share. In that case, the stockholders may be paid according to their investment into the Company.
Non-Participating Liquidation Preference
A non-participating liquidation preference means that the investor gets to choose between (1) receiving their money first or (2) converting their shares to Common Stock and then participating pro rata with the other Common stockholders. The investor will choose whichever option gets them the most money. This is a typical liquidation preference for startup investors.
Participating Liquidation Preference
A participating liquidation preference is less common and usually comes up in later rounds of financing. In this structure, the investor receives (1) their liquidation preference and then (2) gets to share in the proceeds of whatever is left on a pro rata basis. This is sometimes referred to as “double dipping” and is a more investor-friendly preference.
Multiple Liquidation Preference
A liquidation preference with a multiple means that the investor will receive a multiple on their investment. For example, an investor may want a 2x multiple so that they receive twice their money back. Most startups do not have to worry about a multiple preference until a Series A or B round.
Examples
Let’s take a look at a few examples of how liquidation preferences can impact proceeds upon a sale.
ABC Corporation receives a $500,000 investment from Investor Lady in 2021. XYZ Company offers to purchase ABC Corporation for $2,000,000. There are two co-founders who own 80% while Investor Lady owns 20%.
If Investor Lady had a standard seniority, non-participating liquidation preference, Investor Lady would receive $500,000 back first. The two co-founders would then split the remaining $1,500,000 equally.
If Investor Lady had a standard seniority, participating liquidation preference, she would receive $500,000 plus $300,000 (her pro rata portion of the Company) and the two co-founders would split the remaining $1,200,000 equally.
Assuming the same structure as above but Investor Lady has a 2x multiple. She receives $1,000,000 (2x her original $500,000 investment) plus $300,000 (her pro rata portion of the Company). This leaves $200,000 to be split between the two co-founders.
As you can see, the liquidation preference can have a big impact on what a founder will receive from a liquidation or sale of their business. It is one of the first items to be identified in a term sheet and its crucial to understand the implications.
