Liquidation preference refers to the order in which proceeds are distributed in a liquidity event, such as the company being acquired. Venture funds invest in high-risk companies for outsized returns (such as 5x, 10x, 20x, 50x). While venture funds prefer that each of their portfolio companies generate outsized returns, in reality, only a small portion of the portfolio companies will have a 10x or 20x exit. Therefore, liquidation preference protects investors in the scenario where the company does not have a successful exit. In the most common case, it ensures that the investors at least get their original investment amount back.
The company’s Certificate of Incorporation (COI) outlines the company’s liquidation preferences. Venture funds sometimes refer to this as the “liquidation waterfall” as it determines how the proceeds “flow” to the investors and other individuals in the case of a liquidity event. In most COIs, preferred stockholders (who are mostly venture funds and other investors) have the right to receive the greater of (i) a multiple of what they invested initially, or (ii) the amount they would be entitled to if their stock was converted into common stock.
Liquidation preference has variables such as multiple, participation, and seniority (each, described below). The dynamic between these variables determines how much of the proceeds the investors are allocated and how much remains for founders and employees.
The “multiple” of liquidation preference is the amount of capital expressed as a multiple of the investor’s original investment. For example, a 2x multiple would mean that in the case of a liquidation event, an investor who invested $100,000 would get back $200,000.
The most common multiple is “1x”, which means that if the company is acquired, the preferred stockholders receive either their money back or if the liquidation proceeds are less than the amount the preferred stockholders invested, a percentage of the liquidation proceeds based on their ownership percentage.
The liquidation preference can either be participating and non-participating, with the non-participating liquidation preference being the more common of the two. Non-participating means the preferred stockholders receive their multiple (or other percentage first), and then the other stockholders split the rest of the liquidation proceeds. Please note this assume there are no lenders or creditors that may stack first in the liquidation preference ahead of the preferred stockholders. If there are lenders or creditors with priority above the preferred stockholders, then they would receive their portion of the proceeds first, followed by the preferred stockholders and lastly, the other stockholders.
With a participating liquidation preference, preferred stockholders receive their multiple first and then have the ability to participate with the other stockholders in any additional liquidation proceeds. This concept is sometimes referred to as “double-dip preferred” because they are allowed to share in the proceeds twice.
Seniority occurs when multiple serieses of preferred stock exist, which can complicate when each series of stock is paid upon a liquidity event. There are two ways in which the liquidation preference distinguishes among different series of preferred stock: senior liquidation preference and pari-passu.
With a senior liquidation preference, proceeds are paid to the senior preferred stockholders (i.e., investors from the later financing rounds) before they are paid to the junior preferred stockholders (i.e., early stage investors). The company’s COI will distinguish between the senior preferred stockholders and the junior preferred stockholders. Often, the distinction will be among serieses of preferred stock. For example, the Series C and Series D preferred stockholders may be the senior preferred stockholders and stack above the Series A and Series B preferred stockholders who are the junior preferred stockholders. Why? Venture funds have different strategies in terms of their ideal exit. As mentioned above, venture funds want to maximize their returns, but the method for doing so depends on when in the company's life cycle a venture fund invests. Venture funds that invest in an early financing round (such as the Series Seed, Series A or Series B) will likely prioritize pro rata rights because they want the ability to own more of the company as the company becomes successful and they are able to own equity in the company at a cheaper price. Whereas venture funds that invest in later stage companies are more focused on maximizing their return ahead of an exit such as a liquidity event or IPO. As a result, liquidation preference tends to be more valuable to these funds who likely have less time to capitalize on their investment into the company, but want to maximize their return upon an exit.
With a pari-passu liquidation preference, proceeds are paid proportionately to each series of preferred stock in proportion to the total liquidation amount owed to each class. To use an example:
However, if the liquidation preference was pari-passu, the Series B preferred stockholders would receive $6,666,666.67 (i.e., two-thirds of the proceeds), and the Series A stockholders would receive $3,333,333.33 (i.e., one-third of the proceeds).
As with multiples, participation adds to the liquidation stack, meaning there is a higher likelihood of founders receiving less if they allow participating liquidation preferences. Because participating liquidation preferences allow preferred stockholders to “double-dip” they are extremely uncommon.
Participation is highly beneficial for investors. It provides them with a minimum “guarantee” of capital and participation in any additional upside. However, a participating liquidation preference is uncommon, and pushing for it tends to be seen as an aggressive stance.