Liquidation Preference

You may see “liquidation preference” as a term in your term sheet, “liquidation rights,” or simply “liquidation.” This is a big one.

Liquidation preference means that preferred shareholders get paid before anyone else. You’ll often see preference expressed as “a 1X liquidation preference,” where the 1X refers to the multiple—that is, a return of the original investment amount. We discuss preference in detail in Choosing a Financing Structure.

Practically, founders will need to be able to explain liquidation preference when speaking with new investors inquiring as to how much money has been raised to date. Additionally, most seasoned executives will ask about liquidation preference when joining to get an idea of how much the company would have to sell for in order for them to make any money off any stock you offer them.

In the term sheet, you will see a line that says something like, “The proceeds shall be paid as follows.” That’s called the liquidation preference stack, after which the remainder of the proceeds from a liquidity event will be distributed to holders of common stock.

Definition The liquidation preference stack (preference stack or seniority structure) is the order in which a company’s preferred stockholders are paid out in a liquidity event where automatic conversion does not apply. The liquidation preference stack is sometimes referred to as a seniority structure because investors higher up in the payout order are considered to have preference that is senior to those lower in the stack.

In general, preferred stock will be pari passu or “on par with each other,” so everything from Series Seed to Series F stockholders—and all investors in between—get paid out at the exact same time. If there isn’t enough money to pay out all investors, then the funds are distributed to investors according to their ownership percentages. In some cases, the payout may be “last money in, first out,” meaning the most recent investors are able to recoup their money first.* Even in the case of pari passu stock, investors decide whether to exercise their preference or participate via common stock, starting with the most recent investor first, provided that their preferred stock is not automatically converted into common stock. For more on liquidation preference stacks, we recommend Caleb Kaiser’s “Liquidation Preference: Your Equity Could Be Worth Millions—Or Nothing.”

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