What is a liquidation preference?
A liquidation preference dictates the order in which investors are paid out upon a liquidity event. A liquidity event usually means the sale of a company or the majority of a company’s assets. In short, the liquidation preference determines how much the preferred shareholders will be paid from the proceeds of that liquidity event before the other shareholders are paid. It is designed to ensure that investors make money or at least break even in a liquidity event.
There are two major components in a liquidation preference:
1. Preference—The money distributed to the stockholder prior to distribution to other classes of stockholders.
2. Participation—Whether and how the stockholder receives the money distributed to stockholders after the preference has been paid.
Let’s first start with the preference. Preferences are stated in terms of multiples on the money an investor invested. For instance 1x would mean the preference is for 100% of the amount invested, whereas 1.5x would mean 150% of the amount invested.
The most common liquidation preference in Series Seed financing is a 1x. So, if an investor invested $1 million into your company at a liquidation event, they will be paid back $1 million before the common shareholders get paid back anything. Next, let’s look at the participation. After the preference is paid to the investor, the question becomes if and how they will be participating in the remainder of the distribution to shareholders. If an investor invested $1 million in your company with a 1x liquidation preference and you sold it for $21 million.
The investor would first get $1 million, but how will the other $20 million be distributed? That depends on the investor’s participation right. There are three types of participation: (i) no participation, (ii) full participation and (iii) capped participation.
No participation, commonly referred to as a nonparticipating liquidation preference, indicates that the preferred shareholders receive their liquidation preference but no additional proceeds from the liquidation event. In this instance, the investor can elect to either take the preference of their original investment or the proceeds from the sale price based on their ownership percentage in the company.
Take the example where the investor invested $1 million into a startup in exchange for 10% of the company. If the company is sold for $9 million, the investor may elect either to receive $1 million (1x the amount you invested) or 10% shares of the company, which is worth $900K (10% x $9 million). The rational choice would be to receive $1 million. However, if the company is sold for $100 million, the choice would be different. The investor can either receive $1 million or 10% shares of the company, which is worth $10 million (10% x $100 million). The investor would obviously take the $10 million.
Full participation indicates that the investor receives their preference (the multiple of the original investment) first, then receives their percentage of the remaining proceeds from the sale. Full participation means the investor is allowed to fully participate with other shareholders on the remaining balance as common shareholders. Sometimes referred to as “double-dipping,” participating liquidation preference gives shareholders the right to receive payout from the proceeds pool and to “participate” in the remaining proceeds in proportion to their ownership.
For example, if an investor invested $1 million into a startup with a 1x participating liquidation preference in exchange for 20% of the ownership, and the company is sold for $2 million, then the investor will receive the first $1 million (1x the amount invested). In addition, the investor will receive 20% “participation” of the remaining balance. Twenty percent of the remaining balance ($2 million – $1 million) is $200K (20% x $1 million). In total, the investor will walk away with $1.2 million and the common stockholders—the founders and employees—will split the remaining $800K. Participating liquidation preference inflates the exit value for investors and is not welcomed by entrepreneurs. In general, nonparticipating liquidation preference is more common than participating liquidation preference at the seed stage.
Capped participation is a variation of full participation, where the investors get to take their liquidation preference, as well as the proceeds from the sale price based on their ownership percentage, just like full participation. But the twist is that the total payout is capped at a certain amount. The cap sets the ceiling amount an investor would receive under participating liquidation preference. For example, if an investor invested $1 million with a 1x participating liquidation preference on a 3x cap, then they will receive a maximum $3 million in total payout (3 x $1 million).
Take the scenario where the investor has invested $50 million and owns 60% of the company. The company is now faced with a $100 million acquisition. The table below illustrates how each type of liquidation preference produces a different result.
|Type of Liquidation Preference||Payout|
|1x preference, nonparticipating||Receives $60 million:
|2x preference, nonparticipating||Receives $100 million:
|1x preference, participating||Receives $80 million:
|1X preference, participating (3x cap)||Receives $80 million:
In the Series Seed term sheet, the liquidation preference is as follows:
Liquidation Preference: One times the Original Issue Price plus declared but unpaid dividends on each share of Series Seed, balance of proceeds paid to Common. A merger, reorganization or similar transaction will be treated as a liquidation.
Thus, the investor will receive a 1x non-participating preference.
Before leaving, make sure to check our whole guide through SEED funding.