Liquidation Preference is a crucial, but frequently overlooked term for early-stage investors. As a matter of fact, some within the venture capital community recognize it as one of the most essential terms of a deal.
Here’s everything you need to know.
What is a liquidation preference?
A liquidation preference is the amount of money returned to an investor prior to disbursing returns to any other shareholders.
Under these terms, investors are normally reimbursed prior to the company’s:
- Common stockholders
- Original owners/founders
These investments are typically set at 1X the initial investment. Meaning, investors are required to be fully reimbursed ahead of any additional equity holders. This is, of course, after secured debt, and any additional company commitments.
Why liquidation preferences exist
The term exists to protect investors, including from if a business neglects to meet necessary expectations or is sold (liquidated) at a lower than expected value.
In the case of these events, it safeguards a specific minimal payment amount payable to investors.
Note: If a corporation exits through an IPO (Initial Public Offering), liquidation preferences will become insignificant, as all preferred shares generally convert into publicly-traded common stock.
Liquidation preference example
Take a look at these scenarios for four potential results for an investor who wants to invest $1 million for 25% of a business that ultimately ends up selling for $2 million:
Scenario #1: No liquidation preference
- The investor will only receive 25% of the proceeds, equivalent to $500,000, while the common stakeholders will get $1.5 million. This is also a loss of half of an investor’s capital.
Scenario #2: Non-participating at 1.0X liquidation preference
- The investor will receive $1 million from their 1.0X preference, while common shareholders will get the other $1 million.
Scenario #3: Participating 1.0X liquidation preference
- Preferred investors can look forward to receiving $1 million initially, then an additional $250,000 equivalent to 25% of the left over $1 million.
- Common stakeholders will receive $750,000.
Scenario #4: Participating 1.0X liquidation preference with 2X cap
- Preferred investors receive $1 million first, then an additional $250,000. Cap is not a factor in this scenario.
Risk vs. reward is the game at hand in any investment opportunity. Anything to minimize that risk is something investors should take into account. In venture capital, and other types of alternative investments, this rings especially true.
Overall, it’s essential for early-stage investors to consider the terms of their investment, including liquidation preferences, in order to make the safest and most lucrative decisions possible.