Liquidation preference is an essential part of preferred stock and is often considered to be among the most important deal terms in a venture capital investment, second only to the company’s valuation.
To start, preferred stock is typically what startup investors receive, as opposed to the common stock that is given to employees. As its name suggests, preferred stock comes with special rights, including enhanced liquidation preferences. That means they get paid first, ahead of holders of other classes of stock, in the event of a liquidation event. The reason for this being, investors take larger risks by providing startups with what is often significant capital.
The liquidation preference can be triggered not only by the actual liquidation of the company upon dissolution or bankruptcy, but also by the sale of the company, either through stock, assets or merger with another company. The liquidation preference goes away if the company were to go public, as the investor’s preferred stock converts to common stock.
The way the liquidation preference is structured is important, though the significance is not always appreciated by companies and their founders. There are elements that can be varied to create different incentives and returns, such as the amount of the initial preference that will be paid to preferred stockholders. Early investors typically receive a “1x” liquidation preference, which means they can get up to the full amount of their investment back. It is possible that some investors are given up to 2x or 3x liquidation preference, which means they are entitled to a multiple of their original investment (double or triple) before common stockholders get anything. Other important variables to consider are the priority of payments among different series of stock (Series A vs. Series B) and the extent of participation of the preferred stock with the common stockholders in the distribution of the remaining assets.
For companies, the liquidation preference is one of the features that can justify a fair market value differential between the higher purchase price for preferred shares and common stock. This allows the company to sell common stock to employees at a lower price than is paid by venture capitalists. There is what is referred to as “ten-to-one rule,” whereby employees common stock is valued at 10 percent of the price paid by VCs as a market practice. From the company’s perspective, this can be good because the employees view the discount as an immediate profit.