In a venture capital deal, a liquidation preference refers to the payout investors receive in a liquidation event (like a sale or merger) prior to any payments made to the common stockholders. Venture capital investors almost always receive preferred stock, which comes with various negotiated rights and preferences, including a liquidation preference.
A liquidation preference serves as downside protection. Ideally, when a company exits, all stockholders (common and preferred) would receive some upside, i.e. the payout per share would be higher than the highest price per share paid by any investor. But in a lackluster sale, the payout per share could be lower than the purchase price paid by some investors. The liquidation preference provides some protection for investors by ensuring that they get proceeds first before other stockholders.
We’ll go through some examples of how this works in practice below.
What are typical terms of a Liquidation Preference?
Multiplier:
The liquidation preference is typically expressed in terms of a multiple of the original issue price for a series of preferred stock. The multiplier is often 1x, though it can be higher, depending on the risks involved with the investment.
Participation:
After a liquidation preference is paid, the remaining proceeds can be distributed to either (i) both the common and preferred holders based on their proportion of shares held (referred to as “participating”), or (ii) to just the common holders (referred to as “non-participating”). If a liquidation preference is non-participating, the preferred holders would only get their liquidation preference, with no additional return. Note, however, that it is typical for preferred stock to automatically convert to common stock if their pro rata payment is higher than their liquidation preference amount.
Cap:
If a liquidation preference is participating, the participation could be capped. The cap is also typically expressed as a multiplier of the original issue price. For example, investors may receive up to 2x the actual amount of cash invested, and the remaining proceeds would be distributed to just the common holders.
Seniority:
Each series of preferred stock has its own liquidation preference, and some series may be senior to others, e.g. Series B Preferred Stock receives its liquidation preference prior to Series A. Alternatively, series of preferred stock may be paid out on a pari passu basis, meaning that they are paid at the same time, and if funds are insufficient to pay all series back in full, each series would get its proportional cut of the available proceeds.
How does a Liquidation Preference work in practice?
The following are some simple examples of how a liquidation preference would be paid out in a liquidation event (often referred to as a “liquidation waterfall”).
Scenario 1:
200,000 shares of Series A Preferred Stock, issue price of $1.00/share, 1x non-participating liquidation preference
800,000 shares of Common Stock
$500,000 in available proceeds
Stock
Number of Shares
Payout Per Share
Aggregate Payout
Series A Preferred
200,000
$1.00
$200,000
Common
800,000
$0.375
$300,000
Scenario 2:
Same as Scenario 1, except there are now $1,500,000 in available proceeds
If the Series A Preferred only received its liquidation preference, the payout would be as follows:
Stock
Number of Shares
Payout Per Share
Aggregate Payout
Series A Preferred
200,000
$1.00
$200,000
Common
800,000
$1.625
$1,300,000
But here the preferred shares would convert to common. So, the actual payout will be as follows:
Stock
Number of Shares
Payout Per Share
Aggregate Payout
Series A Preferred
200,000
$1.50
$300,000
Common
800,000
$1.50
$1,200,000
Scenario 3:
Same as Scenario 2, except that the Series A Preferred Stock has a participating liquidation preference
Stock
Number of Shares
Payout Per Share
Aggregate Payout
Series A Preferred
Preference
200,000
$1.00
$200,000
Participation
200,000
$1.30
$260,000
Total
200,000
$2.30
$460,000
Common
800,000
$1.30
$1,040,000
Scenario 4:
Same as Scenario 3, except that the Series A Preferred Stock has capped participation at 2x (inclusive of the liquidation preference)
Stock
Number of Shares
Payout Per Share
Aggregate Payout
Series A Preferred
Preference
200,000
$1.00
$200,000
Participation
200,000
$1.00
$200,000
Total
200,000
$2.00
$400,000
Common
800,000
$1.375
$1,100,000
Scenario 5:
Same as Scenario 1, with the addition of 500,000 shares of Series B Preferred Stock, issue price of $1.50/share, 1x non-participating liquidation preference, pari passu with Series A
The available proceeds are insufficient to return the entire liquidation preference to the Preferred Stockholders, so the Series A and Series B holders share ratably, based on the amount that they would have received had proceeds been sufficient to pay all liquidation preferences (which in the case of Series B would be $750,000, and in the case of Series A would be $200,000).
Stock
Number of Shares
Payout Per Share
Aggregate Payout
Series B Preferred
500,000
$0.7895
$394,737
Series A Preferred
200,000
$0.5263
$105,263
Common
800,000
$0.00
$0
Scenario 6: Same as Scenario 5, except that Series B Preferred Stock is senior to Series A
Stock
Number of Shares
Payout Per Share
Aggregate Payout
Series B Preferred
500,000
$1.00
$500,000
Series A Preferred
200,000
$0.00
$0
Common
800,000
$0.00
$0
Scenario 7:
Same as Scenario 6, except that the available proceeds are $1,500,000
