Liquidation Preferences in Venture Capital Financing

The Liquidation Preference is typically the most important economic term in a financing after the valuation because it establishes the relative rights of the preferred stockholders (i.e. the investors) and the common stockholders (i.e. everyone else) with respect to any assets available for distribution. In a sense, the Liquidation Preference puts the “preferred” in “preferred stock,” because it establishes the right of the preferred stockholders to receive preferential distributions of the company’s assets. It applies to a true liquidation in which the company shuts down its operations and dissolves, but more importantly it applies to any so-called “Deemed Liquidation Event,” such as an acquisition by another company, which generates cash or other assets (ex. stock of the acquiring company).

There are three common variations on the liquidation preference. In all three, preferred stockholders are entitled to receive a preferred return – typically some multiple of their original investment (1x-3x) plus any accrued and unpaid dividends – before any payment is made to the common stockholders. The most company favorable alternative – and by far the most common in Seed and Series A rounds – is non-participating preferred stock, which gives the investors the option of receiving the preference amount or the amount they would receive by converting their preferred stock to common stock (more on conversion below). The most investor favorable alternative – which is very rarely seen in Seed and Series A rounds – is fully participating preferred stock, which gives the investors the right to receive the preference amount and share with the common stockholders, on an as-converted-to-common basis, in the distribution of any remaining proceeds (this is generally referred to as “double dipping”). The third alternative, participating preferred stock with a cap, limits the aggregate amount of the investors’ preferred return and by doing so increases the amount the company would have to receive in an exit (relative to if they owned non-participating preferred stock) before the investors would choose to forego their preference and convert to common stock.

It is very rare for investors to insist on participating preferred stock, or even a greater-than 1x liquidation preference, in a Seed or Series A financing, perhaps because they recognize that participating preferred reduces the founders’ economic incentive to build the business and sets a precedent for later rounds that could leave earlier investors worse off. In the overwhelming majority of Seed and Series A financings, the investors ask for, and receive, a 1x non-participating liquidation preference. This is so common that it is rarely a point of discussion. In later rounds, particularly down rounds where the investors have more leverage, participating preferred and liquidation multiples are more common. 

If you do receive a term sheet with participating preferred stock or a greater-than 1x liquidation preference, or both, it is a good idea to do some quick math to determine what different groups of stockholders (investors, founders, employees, etc.) would take home if the company were sold at different price points (for this exercise, assume the entire proceeds of the sale go to the stockholders). You should also consider how the distribution changes with different preferences and participation right, as well as with and without a cap on participation. It is important to try to be realistic about the company' potential exit value, and your goals for an exit, because it will impact how you negotiate the liquidation preference. Keep in mind that the participation aspect of participating preferred stock only comes into play if the proceeds generated from a sale of the company are enough to cover the liquidation preference and then some; if the proceeds are not enough to cover the liquidation preference the participation is irrelevant. On the other hand, a greater-than 1x liquidation preference increases the amount the company must receive in an exit before the founders and other common stockholders receive any proceeds at all, but if the proceeds are great enough the liquidation preference becomes irrelevant. Depending on your goals and expectations, you may be better off agreeing to give the investors 1x participating preferred stock instead of a 2.5x non-participating liquidation preference, or vice versa.