What is a liquidation preference?

June 11, 2007

The most important economic provision in a venture financing other than valuation is probably the liquidation preference.  One of the basic features of preferred stock is providing for an ordering of returns to different classes and series of stockholders upon significant company events. The liquidation preference provision is the principal mechanism to allow preferred stock to receive a priority return upon these events.

The triggering events for a liquidation preference payment typically include both a winding up of the company (e.g. a true liquidation) and a sale of the company through a merger, stock sale, sale of assets or other acquisition of the company (also known as a “deemed liquidation”).  The liquidation preference is meaningless if the company goes public, as the preferred stock issued to investors converts to common stock and the liquidation preference goes away.

The structuring of liquidation preferences is critical and is not always fully appreciated by companies and founders as they set a precedent for future financing rounds, which have significant economic effects.  The elements of the preferences can be varied to create different incentives and returns. The key variables are: (1) the amount of the initial preference to be paid to preferred stockholders, (2) the priority of payments among different classes (preferred versus common) and series (series A versus series B) of stock and (3) the extent, if any, of participation of the preferred stock with the common stockholders in the distribution of the remaining assets.

The liquidation preference is one of the features of preferred stock that companies can point to as a means of justifying the grant of stock options with a “fair market value” exercise price that is lower than the purchase price for the preferred shares in the latest round of financing. The liquidation preference justifies a high price for the preferred stock, such as $1.00/share, while maintaining a low common stock fair market value, such as $0.10/share.  This is good for the company as employees view the discount as immediate “paper” profit.