Understanding Liquidation Preferences

A liquidation preference is exactly what it sounds like, priority treatment for certain stockholders upon the liquidation, sale, merger, IPO or dissolution of a company.  It is a typical Series Preferred Stock right in venture financing transactions.  As I’ve stated in earlier posts, I believe that liquidation preferences are a top negotiating priority at the term sheet stage (I actually believe that this provision carries more weight than the valuation because of how greatly it can impact what you receive in an exit).  The current financing market, as well as the structure of your prior Series Preferred rounds, will drive the type of liquidation preference you can negotiate for yourself.  The purpose of this article is to explain the various types of liquidation preferences and to demonstrate how they can result in markedly different outcomes.

Common Stock in venture-backed companies never have liquidation preference rights.  You will only see liquidation preference rights attached to Series Preferred Stock – the kind that VC funds purchase.  The Series Preferred investors will have a priority in receiving distributions from a liquidation, sale, merger, IPO or dissolution.  Each series of Preferred Stock will have its own liquidation preference and those rights will always be found in the company’s certificate of incorporation.  If you have multiple series of Preferred Stock liquidation preferences, then the preferences get stacked on top of each other with priority generally running “last in first out.”  The size of the liquidation preference is calculated by taking the original purchase price per share (or some multiple thereof) for the respective Series Preferred Stock plus, in some cases, accrued or declared but unpaid dividends.  The more layers of liquidation preference built into a company’s capital structure, the less sale proceeds that will be available to the holders of Common Stock (who typically sit at the bottom of the stack).

There are three ways to structure a liquidation preference for Preferred Stock:

  • Non-Participating Preference – (a/k/a – straight preference).  In this case, the VC fund gets back its original investment plus, in some cases, accrued or declared but otherwise unpaid dividends.  In some cases, the VC Fund may get a multiple of its original investment, meaning that the liquidation preference may be something like “three (3) times the Original Purchase Price plus accrued but unpaid dividends.”  If the VC fund originally invested $2,000,000, then under the example of a 3X multiple the VC Fund would receive $6,000,000 off the top.  If you happen to be raising money in a difficult funding environment, then you can expect that the multiple will be higher.  Multiples in a regular market range from none to 2X.  Multiples creep up towards 4X – 5X in a difficult funding environment or if the company presents additional risk;
  • Participating Preference without a cap – Participating Preferred Stock without a cap provides that after the VC fund gets its liquidation preference on the Preferred Stock, the VC fund then shares in the balance of the sale proceeds with the Common Stock holders on an as-converted basis (meaning that Preferred Stock will be treated as if they converted their shares into Common Stock).  In this case the VC fund may also have a multiple, although some company’s will argue during negotiations that the participating feature eliminates the need for a multiple at the preference phase; and
  • Participating Preference with a cap – Participating Preferred Stock with a cap is effectively the same stock in the preceding bullet point with the distinction that the Preferred Stock holders will stop sharing in the balance of the sale proceeds once their aggregate return reaches a negotiated cap (usually being some multiple of the original purchase price per share).  As an example, if the VC fund negotiates for Participating Preferred Stock with a 5X cap, then it will stop sharing in the balance of the proceeds once its aggregate return (i.e., preference piece plus the shared piece) equals 5X its original investment.

All things being the same, companies gravitate to Non-Participating Preferred Stock and investors naturally gravitate towards Participating Preferred Stock without a cap.  The middle ground is Participating Preferred Stock with a cap.  It should be noted that not all VC funds just default to Participating Preferred without a cap.  Many funds save that structure for companies that pose extra risk, and thus should result in extra return.  Most funds, in an average funding environment, stick with Non-Participating Preferred Stock with some form of multiple.

A fourth option exists for the VC fund.  Some cases exist where the investor may earn back a larger return if it voluntarily converted its Preferred Stock into Common Stock (a common right in venture deals).  What the VC fund obtains as a Common Stock holder may be considerably larger than its preference, participating or otherwise – it’s a matter of doing some calculations ahead of time and figuring out which is the best to own immediately prior to an exit.

The following table shows in clear terms the return outcomes for stockholders in various levels of exits and with different structures of liquidation preferences.  Some interesting facts to note from the example below:

  • The company in this example raised significant money.  The Series B investors put in $25,000,000.  In the case of a tiny exit (like the $10,000,000 example), no one other than the Series B investors will make any money off of the deal.  There’s no incentive for any of the Preferred Stock holders to voluntarily convert to Common Stock in this scenario.
  • In the $100,000,000 example, note the larger return to Common Stock holders in the Non-Participating Preferred scenario.  Also note the difference between the capped and uncapped Participating Preferred scenarios and the shift in returns from the Series A holder to the Common Stock holders because of the cap.
  • In the $1,000,000,000 example, the capped and uncapped Participating Preferred differences should be noted.  In this scenario, if the Preferred Stock holders held the Non-Participating Preferred or Participating Preferred with a cap, those stockholders would be better off converting to Common Stock as it would increase their return significantly.
Cap Table
Shares Liquidation Preference Per Share
Series B Preferred 5,000,000 $5.00 (capped at 3x)
Series A Preferred 5,000,000 $2.00 (capped at 2x)
Common 5,000,000 $0.00
Return to Stockholders

Non-Participating Preference

Participating Preference (Uncapped)

Participating Preference (Capped)

Conversion to Common Stock

Type of Stock
Acquired for $10,000,000
Series B Preferred $2.00 $2.00 $2.00 $0.67
Series A Preferred $0.00 $0.00 $0.00 $0.67
Common $0.00 $0.00 $0.00 $0.67
Acquired for $100,000,000
Series B Preferred $5.00 $9.34 $9.34 $6.67
Series A Preferred $2.00 $6.33 $4.00 $6.67
Common $13.00 $4.33 $6.66 $6.67
Acquired for $1,000,000,000
Series B Preferred $5.00 $69.34 $15.00 $66.67
Series A Preferred $2.00 $66.33 $4.00 $66.67
Common $193.00 $64.33 $181.00 $66.67

So, as you can see, liquidation preferences have a great impact on how the proceeds of a sale are divided – more so than valuation, in my opinion.  If you are trying to figure out where to divide up your negotiating capital, I’d suggest putting a good piece of it behind this provision.  I welcome your comments or questions (use the “Ask VC Deal Lawyer” button on the homepage of the website at www.vcdeallawer.com).

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups, early-stage and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique law firm focused on providing corporate, transactional and operational legal services to start-up, early-stage  and emerging growth companies.

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3 Responses to “Understanding Liquidation Preferences”

  1. Jacin #

    Hi Chris
    Is it ok the following calculation?
    Acquired 100 million; Series B preferred Capped: 9.34 and Common 6.66? I think it should be 15 and 1 respectively.

    03/10/2010 at 7:07 am
  2. Chris McDemus #

    Jacin – thanks for the comment. If you told a founder that if they build a company that would sell for $100M and they they’d only get the value of $1/share when the VCs would get $15/share, I think all of your founders would quit. That’s not enough incentive to work the kinds of hours to build such a company. When, after some years of operating, it appears that such an exit would result in a 15:1 (VCs/founders) split, many VCs consider putting management bonus pools in place to make sure they’d get more than $1/share upon exit – otherwise they risk dis-incentivizing the founder. Thanks again for the comment.

    03/10/2010 at 4:52 pm
  3. MARY #

    If a receiver bypasses the priority of payments and from the proceeds of sale pays shareholders and neglects unsecured creditors, can that be construes as preference? can it be set aside by the court?

    01/10/2011 at 4:38 am