Preferred stock usually has a liquidation preference (or preference), meaning the preferred stock owners will be paid before the common stock owners when a liquidity event occurs, such as if the company is sold or goes public.
Definition A company is in liquidation overhang when the value of the company doesn’t reach the dollar amount investors put into it. Because of liquidation preference, those holding preferred stock (investors) will have to be paid before those holding common stock (employees). If investors have put millions of dollars into a company and it’s sold, employees’ equity won’t be worth anything if the company is in liquidation overhang and the sale doesn’t exceed that amount.*
confusion The complexities of the liquidation preference are infamous. It’s worth understanding that investors and entrepreneurs negotiate a lot of the details around preferences, including:
The multiple, a number designating how many times the investor must be paid back before common shareholders receive proceeds. (Often the multiple is 1X, but it can be 2X or higher.)
Whether preferred stock is participating, meaning investors get their money back and also participate in proceeds from common stock.
Whether there is a cap, which limits the payout if it is participating.
technical This primer by Charles Yu gives a concise overview. Founders and companies are affected significantly and in subtle ways by these considerations. For example, as lawyer José Ancer points out, common and preferred stockholders are typically quite different and their incentives sometimes diverge.