What is Liquidation Preference?
A liquidation preference is a contractual right that gives specified investors priority over common shareholders for available proceeds from a sale, merger or winding up. The amount, participation rights, seniority and covered events depend on the company's governing documents and applicable law.
How Liquidation Preference Works
Liquidation preference dictates the hierarchy of payouts when a company undergoes a liquidation event. There are typically three types of liquidation preferences:
- Non-Participating Preference: Investors receive their initial investment or a specified multiple of it first. Any remaining proceeds are distributed to other shareholders.
- Participating Preference: Investors receive their initial investment or a specified multiple of it first, and then they also participate in the remaining distribution alongside other shareholders.
- Capped Participating Preference: Similar to participating preference, but with a cap on the total amount investors can receive.
The terms of the liquidation preference are outlined in the company's charter and are agreed upon during the investment negotiations.
Example
Consider a scenario where a company is sold for $50 million. The company had previously raised $10 million in venture capital with a 1x non-participating liquidation preference. This means the investors are entitled to receive their initial $10 million investment back before any other shareholders receive proceeds.
- Non-Participating Preference: Investors get $10 million. The remaining $40 million is distributed among other shareholders.
- Participating Preference: Investors get $10 million plus their share of the remaining $40 million alongside other shareholders.
- Capped Participating Preference: Investors get $10 million plus their share of the remaining $40 million, but the total they can receive is capped at a specific amount.
Advantages
Liquidation preferences provide contractual priority, but they do not guarantee full recovery. Actual proceeds may be insufficient, and creditors or other senior claims may be paid first. The outcome depends on the preference terms, capital structure and available distributable proceeds.
Disadvantages
For founders and other common shareholders, liquidation preferences can reduce the amount they receive from a liquidation event. High or multiple liquidation preferences can significantly diminish the returns for these stakeholders, especially if the company is sold for a lower-than-expected price.