Liquidation Preference

What Is a Liquidation Preference?

A liquidation preference is a term found in the investment agreements and governing documents of some preferred stock, most often in privately held companies that have raised money from venture capital firms and other investors. It determines how money is divided when the company is sold or wound down. Holders of preferred shares with this right are paid a specified amount first, before common stock holders receive anything.

How It Works

The preference is usually stated as a multiple of the original investment, such as one times the amount invested. The terms also specify how the preferred holder is paid, and two common structures are:

• Non-participating: the holder either takes the preference payment or converts into common stock, but not both.
• Participating: the holder takes the preference payment and then also shares in the remaining proceeds alongside common holders. This structure is known as participating preferred stock.

Preferences can also be ranked. A newer class of preferred stock may be paid ahead of earlier classes, which is called seniority.

An Illustrative Example

Suppose an investor puts $10 million into a company's preferred stock with a one-times, non-participating preference. Later, the company is sold for $30 million. If the investor's share of the company, after converting to common stock, would be worth less than $10 million, the investor takes the $10 million preference. The remaining $20 million then goes to the other shareholders. If the conversion value were higher, the investor would convert instead. The outcome depends entirely on the specific terms written into the company's documents.

Why It Matters to Investors

Liquidation preferences can significantly affect how much common shareholders, including employees who hold stock options, receive in a sale. In a modest exit, preferred holders with large preferences may be paid first, leaving less for common shares, even when the company's total value appears substantial. Because these terms are negotiated, understanding them requires reading the company's governing documents closely.