When investing in private startups, an investor may come across the term liquidation preference. One important component of a term sheet, liquidation preferences help determine the order in which investors could get paid after a company experiences a liquidation event. In this blog, we’ll answer the following questions: What are liquidation preferences? How do liquidation preferences work? Why are liquidation preferences important for investors to understand?

What are Liquidation Preferences?

Liquidation preferences are an important component of an investment term sheet in the private market. They dictate the order in which investors receive proceeds from a company’s liquidation event such as sale of the company, a merger, or liquidation due to dissolution or bankruptcy. In essence, they can offer a layer of protection to investors by determining who gets paid out and when, if a liquidation happens and the terms allow for the payout.

How do Liquidation Preferences Work?

The mechanics of liquidation preferences are important for both investors and entrepreneurs to understand. When a startup secures funding, investors typically negotiate for specific terms, including the type of liquidation preference, if there is one. There are various types, such as non-participating, participating, and capped participating preferences, each with a unique impact on the distribution of proceeds.

You can think of liquidation preferences like a pie. Liquidation preferences determine the order in which investors get slices of the pie, the size of each pie slice, and which investors don’t get a slice from the pie. Liquidation preferences do assume that there are profits to be distributed to investors after the liquidity event occurs and that there was not a total investment loss realized.

Non-Participating Preference

Under a non-participating preference, investors have the option to either receive their liquidation preference amount or convert their preferred stock into common stock and share in the distribution of proceeds alongside common shareholders. Also known as straight preferred, this structure may provide a degree of flexibility to investors and can align their interests with those of the common shareholders.

With a non-participating liquidation preference, investors can either get their liquidation preference or their share of the remaining proceeds, but not both.

Participating Preference

Also known as double-dipped preferred stock, a participating preference allows investors to receive their liquidation preference and then participate alongside common shareholders with a pro-rata share of the remaining distribution of proceeds. This structure may provide benefits from the upside potential of the company’s sale while helping to recoup their initial investment.

With a participating liquidation preference, investors receive their liquidation preference, plus additional payments in proportion to their ownership.

Capped Participating Preference

Typically seen as an intermediate option, capped participating preference may allow preferred stockholders to receive their liquidation preference and a pro-rate share of the remaining proceeds until a pre-determined multiple of the original investment amount is met.

A capped participating preference sets a limit on how big an investor’s slice can be, no matter how big the pie is.

Liquidation Preference Implications for Investors and Startups

For investors, the choice of liquidation preference can impact potential returns on investments. It can be a balancing act between the principal investment and their share of the upside in the event of a liquidation. Understanding the trade-offs associated with each type of liquidation preference can help you make informed investment decisions.

On the flip side, startups must carefully consider the implications of the liquidation preference structure on their future financing and exit strategies. The type of preference can influence the attractiveness of the investment opportunity to potential investors and impact the distribution of proceeds in a liquidation event.

Navigating Liquidation Preferences

Navigating the complexities of liquidation preferences can require a comprehensive understanding of the investment landscape in the private market. Investors and entrepreneurs alike should consider engaging in thorough due diligence and seeking expert guidance to navigate the negotiation of term sheets effectively.

For Investors

For investors, it can be essential to assess the risk-return profile associated with different types of liquidation preferences and evaluate how they may align with their investment objectives and risk tolerance. Additionally, understanding the broader market trends and the prevalence of various liquidation preference structures can help you choose opportunities that align with your goals.

For Entrepreneurs/Startups

Entrepreneurs, on the other hand, should carefully consider the implications of the chosen liquidation preference on their company’s future fundraising efforts, as subsequent investors may have preferences that differ from those of the initial investors. There could be a need to strike a balance between meeting the demands of early-stage investors and preserving the company’s flexibility for future financing rounds.

Final Thoughts

The concept of liquidation preferences is important for entrepreneurs and startups alike to understand, as they shape investment terms and influence the distribution of proceeds if a liquidity event should occur. By gaining a deep understanding of the mechanics and implications of different liquidation preference structures, investors and entrepreneurs can make informed decisions that align with their respective objectives.

Want to learn more about tips for investing? Check out the following MicroVentures blogs to learn more:

• Tale of Two Metrics: Market Cap and Market Value
• Fulfilling Financial Instruments: Common vs Preferred vs Convertible
• Keeping a Clean Cap Table: Understanding Crowd Notes
• The Investor’s Toolkit: Keeping up with Portfolio Company News

Are you looking to invest in startups? Sign up for a MicroVentures account to start investing!

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.