For those uninitiated in the world of investment and investors, the word liquidation preference may draw a blank stare. But it is a key term for anyone wanting to start a business and eventually get funded.Liquidation preference basically is one of the benefits that comes out of “Preferred Stock” which the investor gets by investing in the Company. Liquidation preference basically means that in the event the company is sold to a third party, or becomes insolvent (gets liquidated essentially), the investor will get a much better exit opportunity than ordinary holders of equity stock in the company.
What are these benefits?
The first and obvious benefit is in terms of the pay-off. In the event that the company becomes insolvent or is sold (hencforth, we will refer to this as a “liquidation event”), the first people to get paid off (after the statutory creditors and other creditors) would be the holders of the ‘preferred’ stock in the Company (i.e. the investors). Only after the preferred investors have been paid off, would the holders of the equity stock get paid.
Are there different kinds of preference?
Yes, there are. Globally, three kinds of preferences prevail. The first is the straight or non-participating preference, which is ideal from the entrepreneurs point of view. The second is the participating preference, which is ideal from the investor’s point of view. And finally, the capped or partially participating preference, which is a hybrid of the above two.
Going into too much detail may be counter-productive, so we will keep it simple. A straight or non-participating preference basically means that in the event of a liquidation event, the investor gets paid off the entire amount of the investment before the equity shareholders get paid off, but nothing more.
In the event of a participating preference, the preferred stockholders not only get a return of their original investment in full, but they are also entitled to enjoy the proceeds of the remaining returns, like the ordinary shareholders. So in effect, the participating preferred shareholders get to have the cake and eat it too, in case a liquidation event happens.
A common practice is to set the liqudiation preference as a multiple of the investment, i.e. at 2 X or 3 X the original investment into the business.
So in case a liquidation event happens, the investor is entitled to a multiple of his original investment into the business. This is quite a risky thing for you as the entrepreneur, because you are then left with no downside protection at all.
What do I do?
Remember that the investor is only doing this to protect his interest, like any rational individual would. So ask for a clear demonstration of what you would get in different scenarios, and if you feel troubled by what you see (for example a multiple coupled with a participating preference), you can explain that to the investor.
There are multiple examples of things going awry with a liquidation preference, so it pays to be a little careful.