Financing Terms & Structures

How liquidation preferences work


The “liquidation preference” is the amount of proceeds from a sale or of the company that the preferred shareholders will receive before the common shareholders are entitled to receive anything.

Standard 1x Non-Participating Liquidation Preference. Typically, preferred shareholders have a liquidation preference equal to the amount of their investment—a “1x” liquidation preference. After the preferred shareholders receive their liquidation preference, the remaining value of the company is paid to the common shareholders. The liquidation preference operates as downside protection to the preferred shareholders. If the value of the company increases sufficiently such that the preferred shareholders would receive more by converting their shares into , then the liquidation preference will be ignored and the preferred shareholders and common shareholders will share in the proceeds together based on their relative ownership percentages of the company. In other words, the preferred shareholders get either their liquidation preference before the common shareholders get paid OR they split the full value of the company with the common shareholders, but not both.

For example, assume the preferred shareholders invested $4 million and own 50% of the company.

 

Scenario 1
Sell the company for $5 million

Scenario 2
Sell the company for $10 million

Preferred Stockholders Receive $4 million preference (i.e., their original purchase price) $5 million based on owning 50% of the company $5 million based on owning 50% of the company
Common Stockholders Receive The remaining proceeds of $1 million $5 million based on owning 50% of the company

Multiple Preference. While not typical, the preferred shareholders may instead have a “multiple” liquidation preference allowing them to receive a multiple (for example, 2x, 3x and so on) of their investment in advance of payments to the common shareholders. This provides more protection to the investors because they are capturing more of the initial value of the company upon a sale or liquidation, but obviously is detrimental to the common shareholders. Continuing with the assumptions above, the where the preferred shareholders have a 2x liquidation preference would work as follows:

 

Scenario 1
Sell the company for $5 million

Scenario 2
Sell the company for $10 million

Scenario 3
Sell the company for $20 million

Preferred Stockholders Receive $5 million $8 million (i.e, 2x their original investment) $10 million based on owning 50% of the company
Common Stockholders Receive $0 The remaining proceeds of $2 million $10 million based on owning 50% of the company

Because of the multiple liquidation preference, common shareholders receive nothing in Scenario 1; and the preferred shareholders would only ignore the liquidation preference and be paid along with the common shareholders based on their relative ownership percentages once the company is sold for at least $16 million (i.e., where 2x the original investment exceeds 50% of the total amount of proceeds from the transaction).

Participating Preferred. Another variation of the liquidation preference is referred to as “participation” or “participating .” With participating , the preferred shareholders receive their liquidation preference (whether 1x, 2x or otherwise) AND they then also share in any remaining proceeds with common shareholders. Again, using the same assumptions as above, participating with a 1x liquidation preference would work as follows:

 

Scenario 1
Sell the company for $5 million

Scenario 2
Sell the company for $10 million

Preferred Stockholders Receive $4 million preference (i.e., their original purchase price), PLUS 50% of the value after the preference is paid for a total payout of $4.5 million $4 million preference (i.e., their original purchase price), PLUS 50% of the value after the preference is paid for a total payout of $7 million
Common Stockholders Receive 50% of the value after the preference is paid for a total payout of $500,000 50% of the value after the preference is paid for a total payout of $3 million

Companies forced to accept participating preferred should try to negotiate a “cap” on participation, which limits investors to an agreed-upon multiple of their liquidation preference (including the amounts received on “participation”), after which common shareholders receive any remaining proceeds from the sale.