Understanding the ins-and-outs of liquidation preferences

A liquidation preference is a feature of preferred stock that specifies how much and the order in which a preferred stockholder is entitled to be paid from the proceeds of a sale or liquidation of a company. The specified amount is called the “preference amount,” while the order in which the stockholder is to be paid is called the “payment priority.”

Preference amount

The preference amount can vary. The preference amount is usually expressed as a multiple of the original price per share of preferred stock. When market conditions are good, liquidation preference multiples for preferred stock sold in venture capital financings are typically one-time (1x) the original price per share. When market conditions deteriorate, or if a particular company is facing headwinds or is perceived as a riskier investment, one can expect to see higher liquidation preference multiples.

Payment priority

The payment priority is expressed in relational terms, and can be senior (paid before), junior (paid after), or pari passu (paid at the same time) to the payment priority of other classes or series (i.e. types) of stock. In the sale or liquidation of a typical company, preferred stock with a liquidation preference will be paid before common stock, which is traditionally last in line for any payments.

Preferred stock liquidation preference

A preferred stock liquidation preference serves as “downside protection” for investors. If a company is sold or otherwise liquidated for a low price, then having a liquidation preference means that the preferred stock investors have a right to be paid back out of any proceeds that are available, up to the preference amount, before anyone else is entitled to receive any payments. On the upside, in a successful exit scenario, another feature of preferred stock, the conversion right, allows preferred stock investors to convert their shares of preferred stock into shares of common stock in the event that the payment the investors would receive as holders of common stock exceeds the preference amount of the preferred stock.

Preference stack

A preference stack (also referred to as seniority structure or liquidation preference stack) establishes the order in which shareholders receive payouts should a liquidation event occur (e.g., acquisitions, bankruptcy, mergers). 

There are three common structures of preference stacks.

• Standard: Should a liquidation event occur, preferred shareholders are paid before common shareholders. Proceeds will be given to preferred shareholders and only then will they go to common shareholders. 
• Tiered: In tiered preference stacks, there are various classes of preferred shareholders, each possessing different liquidation preferences. The top tier is paid first, and only after they have been paid in full will any remaining proceeds be passed down to the next tier, and so on.
• Pari Pasu: All shareholders are treated as equals. No one class of shareholder is given any priority or preference as everyone receives the same percentage of proceeds.

Liquidation preference multiple

Liquidation preference multiples refer to the multiple that will be applied to a specific investor's investment. This in turn determines how much they are entitled to receive in a liquidation event before common shareholders receive any proceeds. 

Participating vs non-participating liquidation preferences

Participating liquidation preferences are investment agreements that enable investors to both receive their liquidation preference and participate in liquidation events with remaining proceeds. On the other hand, non-participating liquidation preferences allow investors to receive only their liquidation preference and do not allow them to receive any further proceeds from the liquidation event.

Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.