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Things to Know About Liquidation Preferences

Aside from valuation, one term that can have a significant impact on an early investor’s overall returns is the liquidation preference. In this post, we aim to explain what liquidation preferences are, why they matter so much, different types, and how they can impact an investor’s (or employee’s) overall returns.

What are liquidation preferences?

Liquidation preference determines the payout order or amount of money that must be returned to investors who hold preferred shares before a company’s common shareholders can receive returns in the case of a liquidation event. A liquidation event can include the sale of the company, a merger, or liquidation due to dissolution or bankruptcy. Liquidation preferences do not apply to common shareholders.

Why do they matter?

Liquidation preferences are designed to protect early investors in the case of a liquidity event, particularly at a lower value than anticipated. Note that if a company exits through an initial public offering (IPO), it is typical for preferred shares to be converted to common shares and preferred stockholders would not be entitled to a payout.

Liquidation preference features and variations

There are four primary variations to consider when it comes to liquidation preferences: participating or non-participating, the multiple, the cap, and seniority structure.

Participating or non-participating

Participating liquidation preference provides for preferential payment, usually of the initial investment plus additional proceeds proportionate to an investor’s equity ownership in the company. Non-participating preferred stockholders can choose between receiving their liquidation preference or share in the proceeds in proportion to their equity ownership. If they choose the latter, they must first convert their preferred shares to and take on any risk inherent of ownership in, common stock.

Multiple

Liquidation preferences are expressed as a multiple of initial investment, typically between 1-2X. A 1X liquidity preference multiple provides for the return of the original investment amount before common shareholders receive anything. A 2X multiple provides for double an initial investment, a 3X triple, etc.

The cap

When liquidation preference is capped, it means that there is a predetermined limit on the amount of capital that can be committed to preferred stockholders. Participating preferred shareholders must convert their shares to common shares to receive any funds over the predetermined cap.

Seniority structure

Investor seniority is another feature that can impact how investors’ returns are paid out. Three common payout structures are standard seniority, pari passu, and tiered seniority.

  • Standard: Payouts occur in order of the latest round of funding to the earliest round. An investor who invested in a company’s Series C round would receive their payout before investors who invested in the Series A round. While this may seem counterintuitive, the reasoning lies in that earlier stage investors rely on capital infusion from subsequent investors to keep the company going.
  • Pari passu: Preferred shareholders across all funding rounds have equal status and priority in the event of a liquidation. Investors in this category each receive a piece equal to their pro-rata share if funds are available.
  • Tiered: With a tiered structure, investors are grouped into tiered levels of seniority at the discretion of the issuing company. At each tier, investor payouts follow the pari passu structure.

Liquidation preferences and impact on potential returns

Now, let’s walk through a few different liquidation preferences to see how they play out in a very simplified scenario. Imagine that an investor invests $1 million into a company (25% of the company), all preferred stockholders have a 1X multiple, and then the company is sold in a cash-only transaction. Assuming that the company receives $5 million in net proceeds after the acquisition:

  • Participating with 1X multiple: Under this scenario, the investor would get their $1 million investment back in addition to 25% of the net proceeds remaining after all stockholders with liquidation preferences are paid their initial investment amount.
  • Non-Participating with 1X multiple: Investors with a non-participating liquidation preference generally exit the investment in one of two ways. The investor could receive their initial $1 million back without any additional proceeds. Alternatively, the investor’s non-participating preferred stock may be converted into common shares, thereby participating in potential upside but forgoing the lower-risk return of principal.
  • Participating 1X multiple with 2X cap: Preferred stockholders would be entitled to their initial investment of $1 million plus net proceeds remaining after all stockholders with liquidation preferences are paid their initial investment amount, with the aggregate payout capped at an amount equal to $2 million. In this case, 25% plus the initial investment would equal $2.25 million, but the investor would receive $2 million.

The example above assumes that the liquidation event is, as a whole, a positive for all investors. It’s important to remember that the terms and dollar amount of the deal will ultimately dictate payout. Depending on preference, some preferred stockholders may realize a profit, some may only receive their initial investment, and some may realize a loss.

There is a lot of flexibility in how liquidation preferences are structured. As an investor, always make sure you fully understand the terms and your position on the cap table before making any commitments.

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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.

 





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