Liquidation Preference

Summary: How Liquidation Preference Works

Liquidation preference decides who gets paid first when a company is sold or shut down. Preferred shareholders (usually investors) are ahead of common shareholders (usually employees and founders). A standard term is 1x non-participating liquidation preference, which means investors get back exactly what they invested before common shareholders receive anything.

If the total exit value is less than or equal to the total liquidation preferences, common shareholders get nothing. If it’s higher, the remaining amount (after paying preferences) is shared according to ownership percentages.

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Key Concepts

• Preferred Shares: Investors’ shares that carry special rights, including liquidation preference.
• Common Stock: What employees and founders typically hold; they are last in line for payouts.
• 1x Non-Participating Preference (Standard):
  • Investors choose either:
    • Their preference (e.g., 1x their invested capital), or
    • To convert to common and take their pro-rata share of the full exit value.
  • They do not get both.
• Participating Preferred (Bad for Employees):
  • Investors get their preference and then also share in the remaining proceeds as if they had converted to common.
• Higher Multiples (2x, 3x):
  • Investors get 2–3 times their invested capital before common sees anything.
• Stacked Preferences:
  • Multiple rounds (Seed, A, B, etc.) can each have their own preferences.
  • Later rounds may be senior to earlier ones, getting paid first.

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Example Recap

Setup:

• Seed investors: $5M in preferred shares, 1x non-participating liquidation preference.
• You: 1% equity at joining, diluted to 0.6% by exit.

Scenario 1: $30M Exit

• Investors’ 1x preference: $5M.
• Remaining pool for common: $30M − $5M = $25M.
• Your payout: 0.6% × $25M = $150,000.
• Without any preference, you would have gotten: 0.6% × $30M = $180,000.
• Cost of the preference to you: $30,000.

Scenario 2: $10M Exit

• With 1x preference:
  • Investors get $5M.
  • Remaining: $10M − $5M = $5M.
  • Your payout: 0.6% × $5M = $30,000.
• If investors had 2x preference on $5M:
  • Preference = 2 × $5M = $10M.
  • Exit value = $10M → all goes to investors.
  • Remaining for common: $0.
  • Your payout: $0, even though the company “exited.”

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What to Watch Out For

1. Participating Preferred