Liquidation Preference: Definition & Calculation
Startups are hazardous investments because they fail so frequently. A liquidation preference is one method that VCs might defend themselves from downside risk.
A negotiated clause known as a liquidation preference grants an investor preferential rewards in the event that the firm is sold or goes through another type of so-called “liquidity event.”
Liquidation preferences can affect how exit returns are allocated, thus it’s crucial for venture capitalists and founders to understand them. It may affect the founders’ capacity to draw in new investors and talent for the business.
Read on as we take a look at exactly what a liquidation preference is, why they exist, its primary features, and how they work.
Table of Contents
- Liquidation preferences help venture capitalists protect their return on the original issue price of preferred stock.
- There are several different parameters that LPs can follow. They include participating, non-participating, capped, seniority, and multiples.
- These clauses aren’t just used in bankruptcy. They’re also used during the sale of a company or when a company closes down.
- Liquidation preference only applies to preferred stockholders. It’s not suggested for an early-stage investor to purchase common stock as it doesn’t provide adequate protection on your investment.
What Is a Liquidation Preference?
Liquidation preference is the second most important factor for venture capital investors. The first is a company’s pre-money valuation. Liquidation preference is important because it determines who gets paid first and how much. It applies to start-up companies choosing to sell, going bankrupt, or going through other liquidation events.
Liquidation preference is usually included as a clause within a contract between a venture capital investor and an early-stage startup company. These preferences give preferred shareholders priority over other common shareholders and debtholders when receiving money back from the potential sale or closure of an early-stage company.
Why Do Liquidation Preferences Exist?
Liquidation preferences are a form of protection for investors and venture capital firms. This is especially true in situations where the company doesn’t meet the profit expectations or sells the company at a lower valuation than what was originally expected.
So even if the company didn’t turn out to be a success, the preferred shareholders are still guaranteed a specific minimum payment regardless of how much the company is valued during an exit or payout.
During a company exit, the following factors impact the payout received by investors:
- Original issue price
- Liquidation preference
- Liquidation multiplier
- Cumulative dividends on preferred stock
- Conversion ratio
Primary Features of a Liquidation Preference
There are several types of liquidation preference dispositions. Each one has certain features or benefits that allow them to be functional in certain investor agreements. These parameters include:
Liquidation Preference Multiple
The multiple refers to the portion that the venture investor is slated to receive ahead of the company’s founder and employees. It can be at a 1X, 2X, or 3X multiple.
This is also referred to as double-dip preferred and is usually in favor of the investor. These types of liquidation preference payouts give the investor their original liquidation preference. They also get additional proceeds from their equity as a stakeholder.
This is most commonly used as the liquidation preference. It allows the venture capitalist to choose between receiving their liquidation preference or sharing proceeds equivalent to their equity ownership after converting preferred shares to common stock. Assuming that the investor acts in their best interest, they’ll select the option that grants them the more ample return.
This type of preference is equally beneficial for the company and the investor. While the investor gets the double-dipping aspect of a participating preference, the returns are capped. That’s why this is sometimes called the “partially participating preferred”.
Seniority refers to the level the investor came in at or the time of investment. This primarily affects when they’re paid. There are three types of seniority to consider:
- Pari Passu
Standard liquidation seniority works in reverse order. Starting with the latest round of investors to the earliest round. So a series B investor would get their money before a Series Seed investor. Pari Passu makes all preferred investors equal in seniority. This allows all investors to share in the proceeds. Tiered seniority is a mix between standard and pari passu format. So investors from different seniority levels are grouped in tiers. Those tiers follow the standard format then the payouts follow pari passu within the different tiers.
How Liquidation Preferences Work
When establishing a liquidation preference, investors often want to make sure they’re paid out before other investors, common shareholders, and debtholders. Venture capitalism is already a risky business. So investors protect themselves from losing money by establishing liquidation preferences via contract.
While bankruptcy is one scenario where liquidation preferences come into play, it’s not the only situation where they’re used. These clauses are also enacted during times such as:
- The sale of a company at a profit
- Going out of business or other liquidation event
When these situations happen, the early-stage investors will get their share of proceeds before shareholders with common stock.
If the preference includes a multiple, then the proceeds are distributed at 1x, 2x, or 3x the original issue price (OIP) of the preferred shares. The OIP is the price that the investor originally paid for the preferred stocks. With standard terms in place, the OIP of the shares is multiplied by the number of outstanding shares.
Liquidation Preference Example
There are several ways that a liquidation preference could play out. Let’s review some simple scenarios where it would be used.
Example 1: A venture capital investor has purchased 250,000 shares of Series A preferred stock at an OIP of $8.00. This comes to a total investment of $2 million. With standard terms, the investor would see a return of $2 million as their liquidation preference.
However, if they have a liquidation multiplier of 2x, they would receive a return of $4 million.
In this situation, let’s say the company was sold for $5 million. Since the investor would receive their cut first, they would get a payout of $ 4 million. The other $1 million from the sale would go to common stockholders, employees, and other equity holders. However, if the company sells for $4 million, the common shareholders wouldn’t get anything.
Overall, liquidation preferences act as protection for early-stage investors. It gives them priority to receive their initial investment back at the very least. It can also come with additional terms in a non-standard preference. The price that a company sells at or is liquidated at can determine how much the investor walks away with. It also determines whether or not the people with common shares receive anything.
FAQs About Liquidation Preference
How is liquidation preference calculated?
A liquidation preference is calculated based on the company’s sales price or liquidation value. The liquidation preference is then deducted from that based on the terms of the preference to distribute to the investors.
What is a 1x liquidation preference?
1x liquidation preference returns the total amount of the original investment to the investor at the exit point.
What does a 2x liquidation preference mean?
A 2x preference multiple doubles the original investment assuming the company is sold at a profit.
What does a 3x liquidation preference mean?
A 3x multiple triples the original investment equivalent to the equity.
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