Liquidation preferences are considered by some to be one of the most important components of an investment term sheet. Generally used to determine investor “pecking order” with respect to distributions related to mergers and acquisitions, liquidation preferences are important for any investor to understand. In this blog, we will explain what liquidation preferences are, how they work, and the different types of liquidation preferences an investor may encounter.
What is a Liquidation Preference?
A liquidation preference is an investment provision that details determines who gets their money first and how much they get when there is a liquidation event, such as a merger or the acquisition of the company. Typically, liquidation preferences come into play after secured debt, creditors, and other company obligations are paid. Owners of preferred stock take precedence over owners of common stock.
Expressed as a multiple of the original investment amount, liquidation preferences are most commonly set at 1x the original investment, meaning preferred stock investors receive 100% of their original investment before holders of common stock can be paid. It is also important to note that if multiple rounds of capital have been raised, each may have unique liquidation preference provisions. 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 different multiple of the initial investment (such as 2X).
Additionally, 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.
Benefits of Liquidation Preferences
Liquidation preferences primarily serve as a form of protection, hedging the downside risk for those who invest in preferred stock.
Types of Liquidation Preferences
There are a few variations within a basic liquidation preference that are important for investors to understand.
While 1x multiple is the most common market standard, it is also possible to see no liquidation preference, a 1.5x multiple, or even a 2x multiple. Not all liquidation preferences are the same, so it is important to understand the initial investment terms.
Participating, Non-Participating, and Capped
- Participating – also known as double-dip preferred stock, a participating liquidation preference favors the participating preferred investor. After receiving the liquidation preference, the investor also receives a pro-rata share of the remaining proceeds
- Non-Participating – also known as straight preferred, the preferred stock investor receives their liquidation preference at the set multiple, but does not receive a share of the remaining proceeds
- Capped Participating – often seen as an intermediate option, the preferred stock investor receives the liquidation preference and a pro-rata share of the remaining proceeds until total proceeds reach a pre-determined multiple of the original investment amount.
- Standard – in standard seniority, liquidation preferences are honored in reverse order than they were issued. For example, Series B investors will receive their liquidation preference before Series A investors, etc.
- Pari Passu – with Pari Passu seniority, all investors receive equal seniority status, all receiving their liquidation preference at the same time. However, if the liquidation event does not provide enough proceeds to cover each investors’ liquidation preference, they are then paid back in proportion to their original investment
- Tiered – a hybrid option between standard and pari passu seniority, tiered seniority, investors from all the various investment rounds are grouped into categories of seniority that follow standard seniority. However, within each tier, investors are paid out on a pari passu seniority basis.
At its core, understanding the differences between each type of liquidation preference is important for any investor to answer the questions of “When will I get paid?” and “How much will I be paid” should a liquidation event occur.
While a liquidation preference may provide preferred stock investors with some peace of mind, it is not a guarantee that you will receive some or all of your investment back. Like all investments, even those with a liquidation preference still have the possibility of a total loss of capital.
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.