A liquidation preference is a term used in venture capital contracts that determines the payout order in the event of a liquidation event, such as the sale of the company (acquisition, merger, etc.), the sale of all of the company’s assets, or its closing. It ensures that certain investors receive their investment back before others receive payouts.
Here’s how it is typically structured:
- Preference Multiple: This defines how much money must be returned to the preferred shareholders before any other shareholders receive a payout. It’s often set at 1x the original investment, meaning that preferred shareholders get back exactly their initial investment before any other distributions are made. However, it can be higher (e.g., 2x or 3x), especially if the investment is perceived as risky.
- Participation: After the initial preference is met, the next step is to determine whether the preferred shareholders have “participating” or “non-participating” preferences.
- Non-Participating: Once preferred shareholders receive their liquidation preference, they do not participate in any further distributions; whatever is left goes to the common shareholders (which often includes founders and employees).
- Participating: After receiving their liquidation preference, preferred shareholders also get to participate in the distribution of the remaining assets on an as-converted basis, alongside common shareholders. This means they effectively get paid twice (or more): first for their preference, and then a share of the leftovers.
- Cap: Some participating preferences have a cap, limiting how much preferred shareholders can receive. Once they hit this cap, they stop receiving additional payouts, and the rest goes to the common shareholders.
- Conversion: Preferred shareholders usually have the option to convert their shares to common stock, typically on a one-to-one basis. They might choose to do this if the total payout to common shareholders would be greater than the liquidation preference amount. This is why the terms often include a clause about when and how preferred shareholders can choose to convert.
- Seniority: Sometimes there are multiple rounds of preferred stock, each with its own terms. In such cases, there may be a seniority structure where later rounds have “senior” preferences over earlier rounds. This means that if there’s not enough money to pay all liquidation preferences, the most senior class gets paid first.
The formulation of a liquidation preference can significantly impact the return for both investors and entrepreneurs. It’s a critical element in the term sheet and is subject to negotiation, with investors seeking to minimize their risk and entrepreneurs aiming to maximize their potential upside.