What is a Liquidation Preference?

Startups are risky investments due to their high failure rates. One of the ways VCs can protect themselves from downside risk is with a liquidation preference.

A liquidation preference is a negotiated provision that gives an investor preferential payouts in the event the company is sold or experiences some other so-called “liquidity event.” For example, an investor holding preferred stock with a liquidation preference might receive their share of the returns before common stockholders—which often includes the founder(s) and employees—can cash in on their shares.

If the return amount is not great enough to repay all existing stockholders completely, liquidation preferences can provide a meaningful increase in the likelihood that the investor receives some of their investment back.

Liquidation preferences are important for VCs and founders to grasp because of the impact they can have on how exit returns get distributed. It can also impact the founders’ ability to attract future investors and talent to the company.

This article will provide an overview of key concepts and industry standards of this important topic.

What Is a Liquidation Preference?

A liquidation preference provision determines theorder in which investors get paid back after a liquidity event. These provisions are designed to provide downside protection in the event of a sale for less-than-expected returns.

The payout order is important because when startups fail or get sold for less than their valuation, there may not be enough funds leftover for all investors to get their money back. Liquidation preferences work to ensure investors holding the liquidation preference are made “whole” before common shareholders can cash in on their shares.

Given the direct impact on returns distribution, a liquidation preference agreement is one of the most important clauses of a term sheet for VCs and founders. It’s often a point of careful negotiation because it requires founders and investors to discuss the prospect of failure head-on and allocate that risk between the various parties involved.

Liquidation Preference Structure

A liquidation preference specifies when and how much investors will be paid back in the event of an exit. The mechanics are based on the preference stack, multiple, and participation rights offered to the investors.

Preference Stack

The liquidation preference stack, also known as the deal’s “seniority structure,” defines the order in which preferred stockholders get paid out during an exit. As companies grow and raise new rounds of financing, new investors might come on to the cap table with their own rights and privileges, including varying liquidation preferences.

Seniority structures bring a sense of order to the process of bringing on additional funding partners. The three most common seniority structures are:

• Standard. Liquidation preference payouts are done in order from latest to earliest rounds. Series B investors get paid back their investment before Series A and seed investors. This model creates the risk of Series A or seed investors receiving back less than they put in or nothing at all.
• Pari passu. With a pari passu liquidation preference, investors from all funding rounds receive proceeds pro rata to committed capital and have the same level of seniority status. If the startup exits for less than its valuation (or amount invested), every investor receives part of the proceeds.
• Tiered. Some term sheets work out payout orders by grouping seniority levels into tiers. This structure is a hybrid between a standard and pari passu design. Within each tier (i.e., Series C-E startups), investors will follow the pari passu payout.

Multiple

Liquidation preferences are usually reflected as a multiple of the original investment amount, i.e., 1x or 2x of the original investment amount.

A 1x liquidation preference is most common. An investor with a 1x liquidation preference gets paid back their full investment amount before any shareholders lower in the priority stack receive their payouts.

A multiple greater than 1x, such as a 2x or 3x liquidation preference, is less common. An investor with a 2x liquidation preference gets paid back double their original investment amount before any shareholders lower in the preference stack receive anything.

Investors and founders should keep in mind that high multiple liquidation preferences (for example, seed investors getting a 3x multiple) can become a sticking point in subsequent funding rounds and may result in granting higher multiples to all subsequent investors—after all, why would the Series A investors accept a 1x multiple when they know the Series Seed investors have 3x? They can also negatively impact the ability for founders and employees to see a return in the future, as these groups of shareholders are pushed lower in the preference stack.

Participation

There are three main types of liquidation preference participation.

1. Non-participating liquidation preference

‍During a liquidity event, non-participating preference (also known as “straight preferred”) stockholders have the option to either (i) receive an amount equal to the liquidation preference multiple, in addition to any unpaid dividends or (ii) convert their preferred shares into common stock and participate in the liquidity event as though they were common shareholders.

If there are ample returns to distribute to investors, it may be worth it to convert to common and receive the price per share for that stock. If returns are limited, it’s often better for the investor to receive their liquidation preference.

An extreme example would be a VC investing $20M with a 1x liquidation preference for a 50% ownership stake in the company. If the startup later gets acquired for $100M, the VC could decide between taking their $20M from the liquidation preference or converting to common stock and receiving $50M from their pro rata share of the proceeds.

2. Full participating liquidation preference

‍During a liquidity event, investors with a full participating liquidation preference (also known as “participating preferred,” “full participating preferred,” or “participating preferred with no cap”) receive (i) their full liquidation preference before anything is available for distribution to common stockholders and (ii) their pro rata of any leftover proceeds alongside the common shareholders. A full participating liquidation preference allows investors to take twice from the returns and is less common than the non-participating liquidation preference.

An example would be a VC investing $5M with 1x fully participating liquidation preference for a 25% ownership stake. If the startup gets acquired for $50M, the VC would first take $5M based on the liquidation preference and then share in the remainder alongside the common stockholders.

3. Capped participation

Capped participation allows shareholders with participating liquidation preferences to only participate with common shareholders until the preferred shareholders receive an aggregate amount of x-times the original investment (this limit being the “cap”). The investor will likely still have the option to convert their preferred shares to common stock to participate fully alongside the common shareholders without a cap, which may be the prudent decision depending on the size of the exit.

Let’s say a VC invests $1M with a 1x participating liquidation preference with a $3M cap for 50% ownership in the company. The maximum amount that the VC can take without converting to common stock is $3M ($1M from the liquidation preference and the remaining $2M alongside the common shareholders). After the $3M cap, common shareholders would split the remaining proceeds.

Liquidation Preference Example

Imagine that an investor invests $3M into an eight-person startup (including the two co-founders). In return for this commitment, the investor will receive 20% ownership of the company (giving the company $15M post-money valuation). The two co-founders will retain 70% total, and 10% would be reserved for the six employees.

Let’s say the company sells a year later for $5M. Without a liquidation preference, payouts would look like this:

• The investor's 20% would be worth $1 million
• The co-founders’ 70% would be worth $3.5 million (or $1.75M per founder)
• The employees’ 10% would be wort $500k (or $83,333 per employee)

In this case, the investor would be down $2M for investing in the company—a negative outcome. However, with a 1x liquidation preference in place, the investor would have received $3M back.

Liquidation preferences become more complex as funding milestones progress. As an example, here is a visualization of Eventbrite’s pre-IPO liquidation preference stack.

Final Thoughts on Liquidation Preferences

Liquidation preferences meaningfully alter the distribution waterfall for paying out investors, founders, and employees. The more an investor is guaranteed to receive, the smaller the amount available for others on the cap table. Both founders and investors should understand what this could mean for future liquidity events.