Whether you are a venture investor or entrepreneur, you’ve most likely heard the the term “liquidation preference”. If you did not know too much about it, you probably searched up a definition on Investopedia or read a few blog posts to familiarize yourself. While those pieces may be a good start, I was shocked to find a lack of in-depth material on the topic given that liquidation preferences are important to any term sheet and returns analysis. The purpose of this post is to provide a detailed guide for both investors and entrepreneurs that breaks down the different types of liquidation preferences and its effects on payout structures.
What is a liquidation preference?
A liquidation preference is a provision meant to serve as protection for investors if a company exits at a value lower than what was initially expected.
To illustrate how it works, let us look at its legal language:
In the event of any Liquidation Event, either voluntary or involuntary, the holders of each series of Preferred Stock shall be entitled to receive out of the proceeds or assets of this corporation available for distribution to its stockholders (the “Proceeds”), prior and in preference to any distribution of the Proceeds to the holders of Common Stock…
A liquidation preference is designed so that preferred shareholders (the investors) receive their money back before any of the common shareholders (employees and founders). Before we dive into details, it is important to understand its use cases and limits. Liquidation preferences are only attached to preferred shares which are typically issued to investors during financing rounds. In this sense, a liquidation preference is ONLY important when a company exits via M&A or sells off its assets during bankruptcy/recapitalization. A liquidation preference is not relevant to public exits because an IPO typically auto-converts all preferred shareholders into common shareholders.
There are four primary features of a liquidation preference:
1. The Multiple
The multiple determines the amount an investor must be paid back before the common shareholders start receiving any remaining proceeds. A 1x liquidation preference means that if you (as a venture capitalist) have invested $1 million (M) into a company, you must be paid back $1M before any common shareholders are paid anything. If the company was sold for $1.5M, you would be guaranteed at least $1M no mater what your equity ownership is. If this company was sold for $900,000, you would be guaranteed the entire proceeds because $900,000 falls under your guaranteed $1M in liquidation preference. For a 2x multiple, you will be paid back $2M (despite only committing $1M) before common shareholders are paid anything. Multiples are typically 1–2x but depending on market conditions, they can be as high as 10x. If you are an entrepreneur, you obviously want the lowest possible multiple to have the least amount of proceeds obligated to the investor.
2. Participating vs. Non-Participating
Non-Participating Liquidation Preference: Under this type, the investor has the option to either 1) exercise his/her liquidation preference or 2) convert their preferred shares into common equivalent shares (where equity ownership % is derived) and be paid a proportion of the proceeds based on their equity ownership of the company. Typical preferred to common conversion rates are 1 to 1 but one should read terms carefully to avoid getting blindsided by a higher/lower conversion rate.
To illustrate the non-participating type, if you have invested $1M into a company with a 1x non-participating liquidation preference in exchange for 20% ownership, and the company was sold for $2M, you will have two payout options. You can exercise your liquidation preference to receive a guaranteed $1M back, or you can choose to convert your preferred shares for $400,000 (20% of $2M). The rational choice would be to obviously exercise the liquidation preference for the higher payout ($1M>$400,000). In this specific example, an exit value of $5M must be achieved for the investor to be indifferent between choosing to exercise or convert since the same payout ($1M) would be achieved under both choices. This point of indifference is called the conversion threshold. An exit value below the conversion threshold would force an investor to exercise his/her liquidation preference. An exit value above the conversion threshold justifies conversion into common equity.
Participating Liquidation Preference: Unlike non-participating, for participating, when the investor has been paid back his/her liquidation preference, they will receive additional “participation” in the remaining proceeds in proportion to their ownership. Let’s say you have invested $1M into a company with a 1x participating liquidation preference in exchange for 20% ownership. If the company was sold for $2M, you would be guaranteed $1M, and then an additional 20% of the remaining proceeds. 20% of the remaining $1M would equate to an additional $200,000 payout, generating a total payout of $1.2M.
Think of participation as double-dipping into the proceeds pool. Participating preferred holders will never convert because they will always have a higher value/share than common shareholders since they are adding their guaranteed liquidation preference value on top of participation (which is the same value as common shares). Founders should avoid participating liquidation preferences as this will always generate a larger exit value for the investor (thus, smaller for the founder) than non-participating liquidation preferences. Participating is less common than non-participating liquidation preferences.
3. The Cap
While liquidation preferences were designed to protect investors, participating liquidation preferences can create unfair scenarios for the entrepreneur. Caps on the amount of committed capital were introduced to protect the entrepreneur. These days, payout caps are typically around 3x the investment amount. An investor committing $1M with 1x participating liquidation preference on a 3x cap will receive up to $3M in total proceeds ($1M liquidation preference + $2M in participation) if he/she does not convert. An investor must choose to convert fully to common to receive any payout higher than its cap. Thus, the cap introduces a conversion threshold for participating preferred shareholders that otherwise would not exist. Below is a waterfall visual of MDx Medical’s (Vitals) 4-tiered, participating liquidation preference with a 3x cap on all investors with the exception of investors in the Series D round. Note that the Series D preferred shareholders will always have a higher price/share value than the common shareholder due to having an uncapped participating liquidation preference. As you can observe, having no cap on participation has an adverse effect on the entrepreneur.
4. Seniority Structures
So far the examples we have been using assume that there is only one investor on the cap table. Typical payout structures are more complicated due to numerous investors with different seniority. It is particularly important for a venture investor to understand seniority structures to determine where they fall in the payout order.
Standard Seniority: In this structure, liquidation preference payouts are done in order from latest round to earliest round. This means that in the event of a liquidation, Series B investors will be paid back their full liquidation preference before Series A investors receive anything. If both Series B and Series A investors commit $1M each with 1x liquidation preference and the company is sold for only $1M, Series B investors will receive the full exit proceeds with Series A investors getting nothing. The majority of startups follow this seniority format. Fundraising is tough for most companies so later stage investors are able to demand priority seniority because earlier investors depend on them to fund the company’s survival.
Pari Passu: For this structure, preferred shareholders across all stages have the same seniority status. This means that every investor will receive a piece of the proceeds. For example, Palantir has completed financing rounds up to Series K with pari passu seniority. Every investor from Series A (2005) to K (2015) has equal priority when receiving exit proceeds.
For pari passu payout, investors share proceeds pro rata to capital committed in the event that there is not enough proceeds to fully cover all investors. To illustrate this, Palantir has raised about $2.7 billion (Bn) in total with 1x non-participating liquidation preferences. Their Series F investors have committed $70M, which is 2.6% of total funds raised; while the Series J investors have committed $400M, which is 14.8% of total funds. If the company was ever liquidated for only $100M, Series F investors will receive $2.6M (2.6% of exit proceeds) in liquidation preferences and Series J investors $14.8M (14.8% of exit proceeds). It is important to note that liquidation preference payouts have nothing to do with equity ownership here.
For investors, the pari passu format makes non-participating payouts complicated. Because non-participation leaves investors with two options (whether to exercise their liquidation or convert), investors’ decisions are mutually dependent on each other’s. Recall that choosing to convert allows one to be paid back in proportion to equity ownership by converting preferred shares into common shares. This conversion into common shares technically means that this payout will happen only after preferred shareholders’ liquidation preferences on your seniority level are paid back. If a company is sold for $100M, an investor with 50% ownership might expect $50M in payout after conversion. However, if every other investor chooses to exercise their liquidation preferences, the converted investor will receive 50% of a significantly smaller remainder of the proceeds (<$100M). The remaining proceeds may fall below this particular investor’s original conversion point. This scenario only happens under pari passu format due to shared seniority.
So while every investor technically has the same seniority, decisions will always start in order of investors with the highest conversion point (typically at the latest stage) to the lowest conversion point. This ensures that conversion decisions are optimal for all parties. Below is a graph that illustrates pari passu non-participation payout values (in terms of price/share) for investors in Palantir. Note that because it is non-participating, all investors have an optimal conversion threshold to common shares.
The pari passu structure is commonly found in unicorn companies, especially those started by prominent founders. Top startups do not have a shortage of funding so later stage investors have no leverage to demand any seniority. In addition, many prominent founders are early stage investors in their own company (i.e. Peter Thiel for Palantir) and would reject any liquidation seniority that was above them.
Tiered: In some cases, investors from different rounds can be grouped up into tiered seniority levels. For example, SpaceX has raised about $1.2Bn across 7 rounds. Their Series G to E investors share the highest level of seniority. Their Series D investors share the middle tier. And their Series A to C investors share the lowest tier among preferred shareholders. Within each tier, investors follow the pari passu payout. You can think of this as a hybrid between the standard seniority and pari passu design.
While this piece breaks down fundamental features of a liquidation preference and provides common seniority arrangements covered by 99% of all startups, it is important to remember that liquidation preferences can be legally structured in any way. Some companies have exotic variations of the typical setups. Thus, it is important to read legal language carefully in a term sheet (if you are a founder) or certificate of incorporation (if you are an investor) to have a clear understanding of where you stand among others on the cap table.