Investors earn a return on their capital when there is an exit event. But how much do they get back, and in which order are they paid?

That’s right, we’re talking about liquidation preferences today!

Let’s say you invest in a company and three years later, the company gets acquired. This is the moment you’ve been waiting for. Time to realize your investment and claim your share of the profits.

But how can you determine what your proceeds will be? It may not be as simple as the percentage of the company you own.  

What’s a liquidation preference?

A liquidation preference is a negotiated provision in an investor’s term sheet that gives investors holding preferred shares first dibs on exit distributions before common shareholders can be paid. When a company is sold, it’s the liquidation preference that determines who gets paid, in which order, and how much everyone walks away with.  

Why liquidation preferences were created

In a perfect world, every investment you make will become wildly successful. In this fantasy, everyone is happy. For example, let’s say you invest $10M and purchase 10% of Company A at a $100M post-money valuation. A few years later, Company A is sold for $1B. With no additional financing, you earned a 10x multiple on your investment and the founders walked away pockets full, happy as well. This is the ending we all hope for.

But, what happens if Company A was sold for just $50M? This would be half of the valuation that you invested in. Without any liquidation preference, you would lose half of your investment, and the founders would likely still walk away with their pockets full and decent smiles. This is a very real possibility, and it’s why liquidation preferences were created: to protect investors from downside risk in the event that their investment isn’t the magnificent outcome they had hoped for.

💵 How do liquidation preferences work

Liquidation preferences have three main characteristics: seniority, multiple, and participation. What that means is: who gets paid first, how much each investor gets paid, and does the investor get to “double dip” in their share of the returns.

Seniority

Liquidation preferences have a “preference stack” which dictates the order in which investors will be paid back. There are different types of preference stacks negotiated, but the most common is called “pari passu,” meaning all investors have the same level of seniority status.

Other examples of preference stacks may give later-stage investors higher priority to be paid back first. Or they may have a tiered structure based on which round you invested in (ie, Series A/B, Series C/D, and so on).

Occasionally, an investor might have invested twice into a tiered preference stack, with one investment early on (last to get paid) and another investment in a later stage round (first to get paid). In this case, the investor may earn a return on their second investment (since they’re the first to get paid), but not on their first investment (last to get paid).

🔢 Multiple

Every liquidation preference will include a multiple of the investor’s original investment that they are entitled to upon an exit event. In early-stage venture capital, this is most often a 1x multiple of the investor’s original investment.

Let’s bring it back to the example above. A $10M investment with a 1x multiple would return you $10M, even though the company lost half of its value since your last investment. After investors receive their liquidation preference multiple, the remaining proceeds would be split among common shareholders.

If an investor negotiated for 2x liquidation multiple, then on a $10M investment in the example above, he/she would earn $20M on the sale of the company, and the rest of the proceeds would be split by common shareholders.

The multiple that an investor and founder agree on can sometimes drag on the negotiations, as it has big implications on the distributions upon an exit event. 2x-3x liquidation multiples are not common during an up-market but you sometimes see this when market conditions become tough.  

🙋 Participation

Participation determines if an investor is able to “double dip” on their distribution returns.

If the liquidation preference is “non-participating,” this means that the investor chooses whether they want to receive their liquidation multiple (for example, 1x their original investment) or convert their ownership percentage into common shares and participate in the distributions as if they were common shareholders. This determination is made based on the distribution outcomes under each scenario, and the investor will go with the option that provides them with a better return.  

For example, in the scenario above, you purchased 10% of Company A at a $100M post-money valuation with your $10M investment. The liquidation preference is 1x non-participating (remember, you have to choose here. No double dipping). The company is then sold for $50M. What do you do?

In this scenario, you have to decide between taking your $10M return from the 1x liquidation preference (this is the amount you invested), or accepting $5M (your pro-rata share of the proceeds from the sale). In this case, you would want to take your 1x liquidation preference of $10M. So you would receive $10M.

On the other hand, if an investor’s liquidation preference is participating, then the investor gets BOTH their liquidation multiple AND their pro-rata share of distributions based on their ownership percentage. For example, using the same scenario, you purchased 10% of Company A at a $100M post-money valuation with a $10M investment. The company is then sold for $50M.

This time, you get both your 1x liquidation preference AND your share of the remaining proceeds. First, you receive $10M back from your liquidation preference. What remains is $40m left from the exit. Remember, you’re still entitled to your pro-rata proceeds from what’s left. You own 10% of the company, so you receive an additional $4m, which means that in total you receive $14M in this scenario.

If you had a 2x liquidation + participating, you would receive 2x back first, which is $20M. And then you would receive your share of the remaining $30M, which is $3M, making your share of the exit worth $23M. Not too shabby! Understandably, this participating option is not as common as non-participating.

If you’re still with me, you’ve made it. We’re done with the terminology.

What to watch out for

As an investor, whether you’re investing your own capital as an angel or investing on behalf of your limited partners, you're going to want to maximize your return potential upon a liquidation event.

When founders raise subsequent capital after your initial investment, it’s possible that new liquidation preference provisions are introduced. It's important to keep an eye out for any clauses that seem excessive or not aligned with your interests.

Once you learn that a new fundraising round is happening, you’ll want to ask for a copy of the term sheet from the founder and quickly flag anything that’s concerning.

Talking to the founder about your concerns early on in the process. before deal terms are papered beyond the term sheet. This is your best time to negotiate. Once a deal is papered, you have little chance of changing any major terms.

Working with an experienced counsel can also provide extra assurance when reviewing deal documents.  

Relish the fine print!

Tucker

This article was written by Tucker McKay. Tucker is the founder of Ikaria Labs, a content marketing agency for funds, fintechs, and financial services companies.

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