Liquidation preference is a valuable part of venture capital that ensures investors get their money back before other common shareholders, such as founders or employees. It’s a setup whereby shareholders’ interests are protected and it helps mitigate the risks of early-stage investments. It’s easy to see why anyone in an early-stage investment position would care about liquidation preferences and why it’s going to be a topic of conversation in those early stages.
Liquidation preferences are important when a company exits through an acquisition or merger, or through bankruptcy/recapitalization. They’re not part of the conversation in a public exit.
Liquidation preferences give a nice extra layer of protection for an early-stage investor, but they can come with extra complications. They also reduce the value of common shares, which often translates into founders/employees who feel less incentive toward maximizing the value of the company.
How Liquidation Preferences are Structured
There are three main preference stack structures you’ll come across when you’re having conversations in these early-stage investment conversations: Standard, Pari Passu, and Tiered. Each of these help define the order in which preferred stockholders get paid out during an exit.
Standard
Standard stack structures mean that investors get paid out in the order from latest to earlier rounds. Those who have invested most recently, get their investment back first, and it works its way back to the initial round. Series A and seed investors hold the highest risk in this scenario.
Pari Passu
Within a Pari Passu structure, investors from any/all funding rounds may receive proceeds with the same level of seniority status, and receive funds pro rata to their committed capital.
Tiered
A tiered structure may include a scenario where payout orders are designated by grouping levels into tiers. Within each tier, investors follow the Pari Passu payout.
Liquidation Multiple
Once you know your payout stack structure, the next big step is to negotiate the liquidation multiple. This designates the amount of the investment that preferred stockholders are due before any common shareholders receive their payouts. If you have high multiple liquidation preferences, you can potentially create problems for future funding rounds and impact the ability for future investors to see a decent return in the future. The actual multiple is going to be different in each deal based on a number of factors like company performance, investor preferences, company goals, and more. This means there’s no one-size-fits-all number.
Participation Rights
The next big step in negotiating liquidation preferences is to discuss the participation rights for distributions of any remaining proceeds beyond their liquidation preference. There are two main scenarios: non-participating and participating. Non-participating preference stockholders can choose to receive an amount equal to the liquidation preference multiple, or they can convert their share into common stock and participate similarly to a common stockholder. On the other hand, an investor can choose to be a participating liquidation preference which allows an investor to get additional payout after the liquidation preference has been fulfilled.
Liquidation Preferences are going to be part of the conversation with any investor, especially the earlier on you are in the rounds. Get a basic understanding of why investors are asking these questions and what the implications are to understand how you and your team may be impacted, as well as how your potential investor will be impacted in the long run as well.