Liquidation Preference: What Da Heck Is It (Part 1)

Judd Aston writes -

I was asking my lawyer about liquidation preference and he bombarded me with legal jargon. Fifteen minutes later I still had not a clue what he had told me. So my question is what is liquidation preference? Some examples would be great.

Bravo. You obviously understand the benefits and convenience of understanding the term yourself or else you wouldn’t be asking your lawyer about it. Like Chris Dixon said, “you can’t outsource the understanding of key financing and other legal documents to lawyers.” It applies to both investors and entrepreneurs.

Of course, you still want to consult professional legal advice before you sign on the dotted line.

(For the purpose of this post, let’s assume only one funding round is required.)

A liquidation preference is a special right attached to preferred stocks that aims to provide some downside protection on your investment. Specifically, the liquidation preference is made up of 2 parts: Preference and Participation.

1. Preference determines the amount you’ll receive, plus any accrued and unpaid dividends, before common stockholders (typically founders and employees) receive anything in a liquidity event (e.g. when the company is sold or goes out of business/asset sale).

The amount is determined by a “preference multiple,” a multiple of what you’d initially paid for your shares. The multiple varies in different deals, ranging from 1x to as much as 10x (for some VCs back then!).

A “1x” liquidation preference (1 times the original price you paid for your shares) is the standard. Too onerous a preference and the founders and employees would lose motivation to take the company to the next level. Which does no help in jacking up the digits in your bank account.

2. Participation determines whether you can “double dip” in a liquidity event. With this right, you’ll

i. receive your Preference AND

ii. participate in the upside (share the remaining assets pro rata with common stockholders as if you held common shares).

Again for the purpose of this post let’s assume you won’t participate. We’ll discuss participation in another post.

The language for a non-participating preferred, 1x liquidation preference might look like this:

Liquidation preference: In the event of a liquidation, dissolution or winding up of the Company, the Preferred will have the right to receive the original purchase price prior to any distribution to the common stock. The remaining assets will be distributed pro rata to the holders of common stock. A sale of all or substantially all of the Company’s assets or a merger or consolidation of the Company with any other company will be treated as a liquidation of the Company.

An Example

• A group of investors, including you, invested $1m in AppleSoft
• All of you hold preferred shares with a 1x liquidation preference
• The founders, Bill and Steve, hold common shares
• Business isn’t doing great and there’s an opportunity for AppleSoft to exit now; otherwise it’ll die a slow, horrible death
• For simplicity’s sake, let’s say there’s no debt, no dividends, and no whatever that complicates matters

Scenario A: AppleSoft is sold for $2m

You guys got your money back. Some for common stockholders as well.

Scenario B: AppleSoft is sold for $1m

Just enough to satisfy your preference. Nothing left for common shareholders.

Scenario C: AppleSoft is sold for $0.5m

You guys are supposed to receive $1m but only $0.5m is available so you and other preferred shareholders will split the proceeds. You lost money on this investment but at least it’s not a total loss.

As you can see, the liquidation preference provides some downside protection on your investment when the exit is less than pretty.

Next, we’ll look at how the preference can prevent the founders from “ripping you off” and what’d happen in multiple funding rounds.