While we touched briefly on this topic in our recent blog on reading term sheets, liquidation preferences are a term that’s worth taking a second look at for early-stage investors. In fact, after a company’s valuation, liquidation preference may arguably play the largest role in an early investors’ overall returns. With that in mind, we hope to explain what liquidation preferences are, variations on them, and how they can impact your returns.

What is a Liquidation Preference?

Upon a corporate liquidation event (distribution of dividends, a merger, or liquidation of the company), liquidation preference basically determines who gets their money first and how much they get. The pecking order usually goes something like creditors, then preferred stockholders, then common stockholders. As laid out in a term sheet, liquidation preference determines how much must be returned to preferred shareholders before common shareholders may receive returns. Liquidation preferences are not applicable to common shareholders.

A multiple of the initial investment, liquidation preferences are usually expressed as 1X or 2X; i.e., the investor would be paid back their initial investment in its entirety or double their initial investment respectively before other equity holders receive any return.

Common vs. Preferred: Pros and Cons in Private Equity

What Purpose Do Liquidation Preferences Serve?

The primary purpose of liquidation preferences is to protect early investors in the chance of a liquidity event. Whether or not the company exits at a higher valuation than that of the early investors’ initial investment, they are guaranteed a minimum payment from the company.

That said, if the company exits via an IPO, liquidation preferences become moot, as all preferred shares are typically converted to common shares at the time of IPO.

Features of Liquidation Preference

Liquidation preferences may be partial, where they apply to less than 100% of the initial investment, full, where they apply to 100% of the initial investment, or at a multiple of the initial investment (such as 2X).

Additional Variations of Liquidation Preference

• Participating/Non-Participating: Preferences may be participating or non-participating. For investors, participating preference is more favorable, as they will be paid back their liquidation preference plus shared additional proceeds in proportion to their equity ownership. More commonly used, non-participating liquidation preferences allow the investor to choose either to receive their liquidation preference or share in the proceeds in proportion to their equity ownership after converting their preferred shares to common.
• Multiple: The multiple of the liquidation preference dictates how much preferred shareholders must be paid back before common shareholders are entitled to receive any returns. Typically, multiples will be 1X or 2X. Of course, for investors, a higher multiple means a bigger payout, and for entrepreneurs, a lower multiple means less obligation to investors.
• The Cap: Caps on the amount of capital that can be committed to preferred. Shareholders were introduced with the aim of protecting entrepreneurs from cases in which participating liquidation could potentially produce unfair outcomes for entrepreneurs. The cap presents a conversion threshold for participating preferred shareholders at which they must fully convert to common shares to receive any more than the set cap.
• Seniority: When it comes to payout structures, determining seniority of investors adds another layer of complication. There are three seniority structures: standard seniority, pari passu, and tiered.

In a standard seniority structure, payouts happen in order, from the most recent round to the earliest round; i.e., a. Series D investor would get their payout before a Series A investor.

Under a pari passu structure, all preferred shareholders across all rounds have equal seniority status. In the event that there aren’t enough proceeds to fully payback each investor, investors will share the proceeds in proportion to their capital commitment. Something to note with this structure is that liquidation payouts are not determined by equity ownership.

A tiered structure is a sort of hybrid between a standard seniority structure and a pari passu structure. Under a tiered structure, investors are grouped into tiered seniority levels; i.e, Series A-C investors would share the lowest tier, Series D investors would hold the middle tier, and Series G-E investors would be at the top tier. Within each tier, payouts follow the pari passu structure.

While what has been described here are features and arrangements that are most common, you should know that liquidation preferences have the legal flexibility to be structured any way a startup would like, and you may encounter unique structures that vary greatly from what is presented here. Whether you’re a founder or investor, you should always, always be sure you understand where you fall on a company’s cap table.

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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.