The term ‘liquidation preference’ is one of the essential components of a preferred stock agreement – it’s generally considered the second most important term in a venture capital investment and it’s outlined on the term sheet. (See How do you Understand a Series A Term Sheet for term sheet details.)
So, what is a ‘liquidation preference’ and what does it mean to business owners and investors?
Term Sheet Facts – Types of Stock
The following are the two most common types of stock and who holds each type:
Common Stock – the basic equity interest in a company. Typically the type of stock held by founders and employees.
Preferred Stock – has some ‘preferences’ over common stock like dividend and redemption rights, conversion and voting rights, etc. Typically owned by venture capitalists and other investors in the company.
Venture capital investors almost always insist upon having preferred stock because the holders of such stock receive preferential treatment in the case of a liquidation event. Of course, there are many other rules on preferred stock including participation, capped participation, and others but we’ll focus on these two primary types of stock for our purposes.
Liquidation Preference Usually Means Preferred Stock
The ‘liquidation preference’ refers to the dollar amount that the stockholder of a preferred stock receives prior to holders of common stock in the event the company is sold or otherwise liquidated and its assets are distributed to stockholders. Typically, a liquidation preference is for one times (1X) or higher return on capital.
Let’s look at a simple example: a company raises $10 million in venture capital funding in exchange for a 30% stake in the company. Later, it’s sold for $25 million and the venture investors collect $10 million in the form of a liquidation preference known as 1X. It covers the dollars invested on a one-to-one basis and even through the investor’s ownership would entitle them to only $7.5 million, they receive the full $10 million they invested.
Preferred stock has downside protection in case of a distressed sale of the company but the upside of owning the preferred stock is limited. Preferred stock can be converted to common stock, so investors have unlimited upside if they convert but then they forego their liquidation preference.
Typical Liquidation Preference Amounts
The most common liquidation preference amount is 1X but some agreements have multiple liquidation preferences, which means the preferred stockholders are entitled to a multiple of 2X or 3X their original investment before common stockholders get a dime.
Here’s a simple example: if a company were sold for $40 million and the venture capitalist invested $5 for a one-third stake in the company and had a 2X preferred stock agreement, that investor would receive the first $10 million right off the top including any accrued dividends plus another $10 million for a total of $20 million – half the company’s value even though they only own one-third of the company.
Small business owners are warned to be very careful about accepting term sheets with liquidation preferences. Work with an attorney to be sure the terms you are getting are something you can live with later.