An investor’s right to have their money returned before common stock holders, which usually includes founders and employees of a company, is called a liquidation preference. In other words, the liquidation preference determines how much money must be returned before founders and employees of a company can receive returns in case of liquidation such as the sale.
The initial investment is multiplied by the liquidation preference. Most commonly, they are set at 1X. This means that investors would have to pay back the entire amount of their initial investment before any equity holders.
It is important to remember that preferred stock holders are eligible for liquidation preferences. This is why early-stage investors don’t purchase common stock.
Why Do Liquidation Preferences Exist?
Investors can use liquidation preferences to protect themselves if a company does not meet its expectations, sells or liquidates for a lower value than they expected. The liquidation preference guarantees investors a minimum payment regardless of whether the company is sold or liquidated.
It is important to remember that liquidation preferences do not apply to companies exiting via an IPO (“Initial Public Offer”), since all preferred shares convert automatically into publicly-traded common stocks.
Are All Liquidation Preferences The Same?
Although industry standards exist, not all liquidation preferences will be the same. The differences between investors can affect investors’ returns. When evaluating liquidation preferences, these are some key parameters to keep in mind.
Liquidation Preference Multiple
The multiple, as mentioned above, determines how much must be returned to investors before founders and employees get returns. When investing in companies at the early stages, preferred stock holders should expect to get at least the market rate 1X liquidation preference.
Participating, Nonparticipating, or Capped Liquidation Preference
Investors find the Participating Liquidation Preferences, also known as “Double Dip Preferred”, most attractive. Investors who have preferred stock that includes participating liquidation preferences will receive a refund of their liquidation preference. The investor will then share in the additional proceeds proportionately to his or her equity ownership.
These preferences are also known as “Straight Preferences”, and are the most common. Investors who have preferred stock that has non-participating liquidations preferences can choose to (1) receive their liquidation preference or (2) share the proceeds proportionally to their equity ownership. An investor will rationally choose the option that provides the highest return.
Capped liquidation preferences are also known as “Partially Participating Preferences” and are equally beneficial to both investors and companies. A capped liquidation preference in an investor’s preferred stock will mean that he or she will receive back the liquidation preference and will then share in the additional proceeds proportionately to his or her equity ownership. These preferences would limit investors’ returns, but the name suggests otherwise. Investors may find it advantageous to convert preferred shares into common shares and give up liquidation preferences. Instead, they will receive proceeds proportional to their equity ownership.
Seniority
Standard Seniority is the structure that most companies in their early stages follow. Standard seniority allows liquidation preferences to be honored in reverse order, from the most recent round to the earliest. This means that Series B investors would be eligible for liquidation prior to Series A investors. Series Seed investors would also be eligible for liquidation preference.
Pari Passu (a Latin phrase meaning “equal footing” ) Seniority grants all preferred investors equal seniority, which means all investors would receive at least some of the proceeds. If the proceeds of a sale are not sufficient to cover all investors’ liquidation preferences, payouts will be made proportionately to the amount invested (which is not always correlated to ownership).
Tiered seniority is a mix of standard and pari passu seniority. Tiered seniority allows investors from different funding rounds to be grouped into distinct seniority levels. These seniority levels follow the standard seniority format. The payouts for each tier follow the pari passu format.