Insights

What is Liquidation Preference?

Emerging Companies & Venture Capital

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
StockNumber of SharesPayout Per ShareAggregate Payout
Series A Preferred200,000$1.00$200,000
Common800,000$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:

StockNumber of SharesPayout Per ShareAggregate Payout
Series A Preferred200,000$1.00$200,000
Common800,000$1.625$1,300,000

But here the preferred shares would convert to common. So, the actual payout will be as follows:

StockNumber of SharesPayout Per ShareAggregate Payout
Series A Preferred200,000$1.50$300,000
Common800,000$1.50$1,200,000

Scenario 3: Same as Scenario 2, except that the Series A Preferred Stock has a participating liquidation preference

StockNumber of SharesPayout Per ShareAggregate Payout
Series A PreferredPreference200,000$1.00$200,000
Participation200,000$1.30$260,000
Total200,000$2.30$460,000
Common800,000$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)

StockNumber of SharesPayout Per ShareAggregate Payout
Series A PreferredPreference200,000$1.00$200,000
Participation200,000$1.00$200,000
Total200,000$2.00$400,000
Common800,000$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).

StockNumber of SharesPayout Per ShareAggregate Payout
Series B Preferred500,000$0.7895$394,737
Series A Preferred200,000$0.5263$105,263
Common800,000$0.00$0

Scenario 6: Same as Scenario 5, except that Series B Preferred Stock is senior to Series A

StockNumber of SharesPayout Per ShareAggregate Payout
Series B Preferred500,000$1.00$500,000
Series A Preferred200,000$0.00$0
Common800,000$0.00$0

Scenario 7: Same as Scenario 6, except that the available proceeds are $1,500,000

StockNumber of SharesPayout Per ShareAggregate Payout
Series B Preferred500,000$1.50$750,000
Series A Preferred200,000$1.00$200,000
Common800,000$0.6875$550,000