What is a liquidation preference and what is a typical liquidation preference?

Takeaway: Liquidation preferences are rights to receive proceeds in an acquisition before other stockholders. They are usually given to investors in preferred stock financings. The effect of these is that, in some acquisitions, the investors get their money back before the founders and employees get paid.

Liquidation preferences are a crucial aspect of preferred stock investments made by venture capital funds. These preferences define the order and priority of payouts to investors in the event of a liquidation event, such as a merger, acquisition, or IPO. In this post, we will explain what a liquidation preference is, its importance, and the market standards for liquidation preferences in venture capital investments.

What is a Liquidation Preference?

A liquidation preference is a contractual provision that determines the priority and amount that preferred stockholders receive during a liquidity event, such as a sale, merger, or initial public offering (IPO) of the company. It is designed to protect investors by ensuring that they receive a return on their investment before other stockholders, such as founders or employees holding common stock, receive their share.

The liquidation preference is typically expressed as a multiple of the original investment made by the investor. For example, a 1x liquidation preference means that the investor would receive their original investment amount back before any proceeds are distributed to common stockholders.

Market Standards for Liquidation Preferences

In venture capital investments, the market standard for liquidation preferences varies depending on factors such as the stage of the company, the size of the investment, and the negotiating power of the investor. However, there are some common market standards that can provide a general understanding of what is considered "normal" or "acceptable" in the industry.

1x Non-Participating Liquidation Preference

The most common market standard for liquidation preferences is the 1x non-participating preference. In this scenario, the investor receives their original investment back (1x) before any proceeds are distributed to common stockholders. Once the investor has received their liquidation preference, the remaining proceeds are distributed to common stockholders, and the preferred stockholder does not participate in any further distribution.

This structure is considered fair and balanced, as it provides a level of protection for investors without disproportionately favoring them over common stockholders in the event of a successful exit.

Participating Liquidation Preference

A participating liquidation preference allows the preferred stockholder to receive their liquidation preference (usually 1x) and then also participate in the distribution of the remaining proceeds alongside common stockholders on a pro-rata basis. This structure can be more favorable to investors, as it provides them with additional upside in the event of a successful exit.

However, participating liquidation preferences are less common in today's market, as they can be viewed as overly investor-friendly and may potentially disincentivize founders and employees.

Higher Liquidation Preference Multiples

In some cases, investors may negotiate for a higher liquidation preference multiple, such as 2x or 3x. This means that the investor would receive two or three times their original investment before any proceeds are distributed to common stockholders. Higher liquidation preference multiples are more common in situations where the investor perceives a higher level of risk.

While these structures can provide increased protection for investors, they may also create misalignment between investors and the founding team and potentially impede the company's ability to raise future rounds of financing.

Conclusion

Liquidation preferences play a vital role in protecting investors and shaping the distribution of proceeds during liquidity events. Understanding the market standards for liquidation preferences is essential for both startups and investors, as it enables them to negotiate fair and balanced terms that align the interests of all parties involved. By striking the right balance between investor protection and founder incentives, companies can create a solid foundation for long-term success and growth.