Ask a MoFo: Common Provisions in Venture Capital Term Sheets: Liquidation Preference

The following article is part of our "Ask a MoFo" series, where we address some of the frequently asked questions our MoFo startup team is asked during the course of business. These questions span the entirety of the startup lifecycle – from questions relating to incorporation, to tips for a successful exit. We encourage you to submit questions you would like to see answered as part of this series to ECVCevents@mofo.com.

What is a Liquidation Preference?

Imagine your venture-backed company is sold, or (yes, it can happen) goes bankrupt—in both scenarios, investors want to know: who will get paid, and in what order?

A “Liquidation Preference” is a right that allows preferred stockholders to receive the proceeds of their original investment before common stockholders if a company is sold, goes bankrupt, or otherwise substantially liquidates its assets. In later stage companies, there can be additional layers of preferred stock with different levels of seniority, but for purposes of this article we’ve just assumed there is one layer of preferred for simplicity. Although there are several types of Liquidation Preferences, which vary in favorability towards preferred stockholders, they generally follow this basic pattern:

Liquidation event occurs, wages are paid, and all debt is settled.

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First pay X times the original investment to Preferred (or as-converted to common stock value if greater).

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Pay remaining amounts (if any) to common stockholders.

How high to multiply?

In the above example, X is some multiple of the investors’ original investment – for example, a 1x “Liquidation Preference” means the stockholder can expect to get 100% of its money back (if there are enough funds after settling debts) even if its proportional share of deal proceeds would otherwise have resulted in it not recouping its initial investment amount. This multiple is usually 1x, but it can be 2x, 3x, or even higher. A high multiple can be more enticing to investors, at least up to the point at which the common stockholders (and therefore founders and employees) become so unlikely to receive any deal proceeds that they become unmotivated to continue working to maximize the value of their equity. Ultimately, the multiple depends on leverage when negotiating the terms of a financing and what type of Liquidation Preference is agreed upon.

Types of Liquidation Preference

1. Non-participating Liquidation Preference

“Non-participating Liquidation Preference” is the most common type of Liquidation Preference. A non-participating preferred stockholder receives the greater of 1) the agreed multiple of its initial investment (to the extent there are sufficient proceeds); OR 2) the value of its shares if they were converted to common stock pursuant to the then effective conversion ratio (which starts at 1:1). You can think of this type of Liquidation Preference as simply downside protection.

2. Participating Liquidation Preference

“Participating Liquidation Preference” is the scheme that is most favorable towards investors. A participating preferred stockholder gets back some multiple of its investment before common stockholders AND gets to participate in the distribution of proceeds with the common stockholders pro rata on top of the fixed amount. This less common variation of Liquidation Preference turns the downside protection of Non-participating Liquidation Preference into both downside protection and a minimum multiple of upside in a successful exit.

3. Capped Liquidation Preference

A “Capped Liquidation Preference” behaves the same as a Participating Liquidation Preference, but with a maximum cap on earnings unless the investor converts to common stock. A Capped Liquidation Preference has the benefit of downside protection when proceeds are limited, but reduces potentially outsized outcomes for particularly successful exits. In this formulation, the investor would be entitled to the greater of 1) the agreed multiple of its initial investment (to the extent there are sufficient proceeds), participating pro rata with the common stockholders up to a maximum of another multiple of its initial investment (e.g. a 1x Liquidation Preference, participating but capped at 2x the investor’s initial investment amount); OR 2) the value of its shares if they were converted to common stock pursuant to the then effective conversion ratio (which starts at 1:1) giving up its Liquidation Preference. This provides the downside protection of non-participating preferred and a more limited version of the limitless upside presented by standard participating preferred.

What if my company has multiple series of preferred stock?

As mentioned above, in later stage companies with multiple series of preferred stock, there is the additional question of seniority amongst the series of preferred stock. Most companies start out with pari passu (meaning equal footing), with all series of preferred having the same priority, but depending on the dynamics between rounds you might see more recent series of preferred having priority of payment over older series of preferred (e.g. Series C gets paid then Series B then Series A then Common Stock) or certain groups of preferred having priority over other groups (e.g. Series C and Series B are on equal footing with each other and get paid before the Series A and Series Seed who are on equal footing with each other and get paid before the Common Stock).

Final Thoughts

Liquidation Preference terms should clearly state which events will trigger Liquidation Preference rights. See the NVCA model term sheet for example language. Given the various scenarios outlined above, which can have real world economic consequences for everyone on the cap table, it is critical to consult counsel when negotiating Liquidation Preferences and other material terms of a proposed preferred stock investment.