Whether you are an experienced venture investor or an aspiring entrepreneur, you’ve likely come across the term “liquidation preference” during your journey in the world of startups and finance. While a basic understanding of this provision can be found through simple searches or introductory blog posts, there is a surprising dearth of comprehensive material on the subject, considering its paramount importance in term sheets and returns analysis. This article aims to bridge that gap and offer an in-depth guide that not only breaks down the different types of liquidation preferences but also explores their profound effects on payout structures.

Understanding Liquidation Preferences

At its core, a liquidation preference is a protective provision designed to safeguard investors in the event of a company’s exit at a valuation lower than expected. To comprehend how this works, let’s delve into 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…”

In essence, a liquidation preference ensures that preferred shareholders, typically investors, receive their investment capital back before any distribution to common shareholders, which includes employees and founders. However, to truly grasp the nuances and implications of liquidation preferences, it is essential to explore their use cases and limitations.

Liquidation Preference Types and Their Features

Liquidation preferences come in various forms, each with its unique features that can significantly impact how payouts are distributed. Four primary features of liquidation preferences include:

1. The Multiple

The multiple is a critical component of liquidation preferences, determining the amount of money an investor must be paid back before common shareholders receive any remaining proceeds. For instance, a 1x liquidation preference means that if a venture capitalist invests $1 million into a company, they must be paid back $1 million before any common shareholders receive a share. Even if the company is sold for $1.5 million, the investor is guaranteed at least $1 million, regardless of their equity ownership percentage. Higher multiples, such as 2x, would require the investor to be paid back twice their investment before common shareholders receive anything. Multiples typically range between 1x and 2x, but market conditions may influence them, leading to higher multiples of up to 10x. For entrepreneurs, it is ideal to have the lowest possible multiple to minimize the amount of proceeds obligated to investors.

2. Participating vs. Non-Participating

The type of liquidation preference, whether participating or non-participating, significantly impacts the payout structure for investors. 

Non-Participating Liquidation Preference

Under this type, the investor has the option to either exercise their liquidation preference or convert their preferred shares into common equivalent shares, where equity ownership percentage is derived. The investor then receives a proportionate share of the proceeds based on their equity ownership. While typical preferred to common conversion rates are 1 to 1, careful attention should be given to the terms to avoid unexpected outcomes due to higher or lower conversion rates.

For example, if an investor has invested $1 million into a company with a 1x non-participating liquidation preference in exchange for 20% ownership, and the company is sold for $2 million, the investor will have two payout options. They can either exercise their liquidation preference to receive a guaranteed $1 million back, or they can choose to convert their preferred shares for $400,000 (20% of $2 million). The rational choice would be to exercise the liquidation preference for the higher payout ($1 million > $400,000). In this example, an exit value of $5 million would be required for the investor to be indifferent between exercising or converting, as both choices yield the same payout ($1 million).

Participating Liquidation Preference

Unlike non-participating, for participating liquidation preferences, once the investor has been paid back their liquidation preference, they are entitled to receive additional “participation” in the remaining proceeds, proportionate to their ownership percentage. Let’s say an investor has invested $1 million into a company with a 1x participating liquidation preference in exchange for 20% ownership. If the company is sold for $2 million, the investor is guaranteed $1 million, and then an additional 20% of the remaining proceeds, which equates to an extra $200,000, resulting in a total payout of $1.2 million.

Participation can be seen as “double-dipping” into the proceeds pool, as participating preferred shareholders will always have a higher value per share than common shareholders, since they add their guaranteed liquidation preference value on top of participation (which has the same value as common shares). For founders, it is generally better to avoid participating liquidation preferences, as they tend to generate a larger exit value for the investor (and a smaller value for the founder) compared to non-participating liquidation preferences. It is worth noting that participating liquidation preferences are less common than their non-participating counterparts.

3. The Cap

While liquidation preferences were initially introduced to protect investors, the concept of participating liquidation preferences can lead to potentially unfair scenarios for entrepreneurs. To address this issue, payout caps on the amount of committed capital have been introduced to protect the entrepreneur’s interests. These caps typically limit the total proceeds an investor can receive.

Payout caps are commonly set at around 3x the investment amount. For instance, if an investor commits $1 million with a 1x participating liquidation preference on a 3x cap, they will receive a maximum of $3 million in total proceeds (comprising the $1 million liquidation preference and an additional $2 million in participation) if they do not choose to convert. Any payout exceeding this cap requires the investor to convert their preferred shares fully to common shares. Consequently, the cap introduces a conversion threshold for participating preferred shareholders that would not exist otherwise.

To illustrate this further, consider a waterfall graph depicting MDx Medical’s (Vitals) 4-tiered, participating liquidation preference structure with a 3x cap on all investors, except those in the Series D round. As observed, Series D preferred shareholders will always have a higher price per share value than common shareholders due to their uncapped participating liquidation preference.

4. Seniority Structures

So far, the examples we have explored assume a simple scenario with only one investor on the cap table. However, in reality, startup cap tables often include numerous investors with varying seniority. Understanding seniority structures is particularly crucial for venture investors to determine their position in the payout order.

Standard Seniority

In this structure, liquidation preference payouts are done in order from the latest round to the earliest round. Consequently, if a liquidation event occurs, Series B investors will be paid back their full liquidation preference before Series A investors receive anything. For example, if both Series B and Series A investors commit $1 million each with a 1x liquidation preference, and the company is sold for only $1 million, Series B investors will receive the full exit proceeds, while Series A investors will not receive any payout. This standard seniority format is prevalent among startups, as fundraising can be challenging, and later-stage investors often demand priority seniority since earlier investors rely on them to fund the company’s survival.

Pari Passu

In this structure, preferred shareholders across all stages have the same seniority status. In other words, every investor will receive a share of the proceeds based on their investment percentage. For instance, Palantir, a well-known tech company, has completed financing rounds up to Series K with pari passu seniority. Consequently, every investor from Series A (2005) to K (2015) has equal priority when receiving exit proceeds.

Under the pari passu payout arrangement, investors share the proceeds pro rata to the capital they have committed, should there be insufficient funds to fully cover all investors. To illustrate this, consider Palantir, which has raised about $2.7 billion in total with 1x non-participating liquidation preferences. If the company is liquidated for only $100 million, Series F investors, who committed $70 million (2.6% of total funds raised), will receive $2.6 million (2.6% of exit proceeds) in liquidation preferences, while Series J investors, who committed $400 million (14.8% of total funds), will receive $14.8 million (14.8% of exit proceeds). It’s crucial to note that these liquidation preference payouts have nothing to do with equity ownership.

For investors, the pari passu format introduces complexity in non-participating payouts. Since non-participation leaves investors with two options – exercising their liquidation preference or converting to common shares – their decisions are mutually dependent on each other’s. For instance, if an investor chooses to convert, they will be paid back in proportion to their equity ownership by converting their preferred shares into common shares. However, this conversion means that the payout will occur only after preferred shareholders at their seniority level receive their liquidation preferences. Thus, in certain scenarios, a company’s sale might result in a payout that falls below an investor’s original conversion point, which can happen solely under the pari passu structure due to shared seniority.

While all investors in a pari passu structure have the same seniority, the decisions on exercising liquidation preferences or converting to common shares will always start with investors with the highest conversion point (typically at the latest stage) and move down to those with lower conversion points. This ensures that conversion decisions are optimal for all parties involved. The graph below depicts pari passu non-participation payout values (in terms of price per share) for investors in Palantir.

The pari passu structure is commonly found in unicorn companies, especially those founded by prominent entrepreneurs. As top startups usually have ample access to funding, later-stage investors have less leverage to demand seniority. Moreover, many prominent founders are early-stage investors in their own companies (e.g., Peter Thiel for Palantir) and would vehemently reject any liquidation seniority that ranks above them.

Tiered

In some cases, investors from different rounds can be grouped into tiered seniority levels. For example, let’s consider SpaceX, which has raised about $1.2 billion across seven rounds. In this structure, Series G to E investors share the highest level of seniority, Series D investors share the middle tier, and Series A to C investors share the lowest tier among preferred shareholders. Within each tier, investors follow the pari passu payout. This tiered approach can be seen as a hybrid between the standard seniority and pari passu designs, offering a nuanced solution that caters to the specific dynamics of the cap table.

This article has provided a comprehensive guide to understanding liquidation preferences, delving into their intricacies, types, and features, and exploring the impact they have on payout.