Liquidation Preference

How a liquidation preference works

A liquidation preference is a payment priority, written into the charter, that applies whenever the company distributes proceeds to stockholders.

The NVCA model term sheet's liquidation preference clause opens by stating that in the event of any liquidation, dissolution or winding up of the company, the proceeds shall be paid in a specified order, and then gives three alternatives.

Alternative one, non-participating preferred, provides that the company first pays a stated multiple of the Original Purchase Price on each share of preferred, plus declared and unpaid dividends where applicable, or, if greater, the amount the preferred would receive on an as-converted basis, with the balance distributed pro rata to holders of common stock.

Alternative two, full participating preferred, provides that the company first pays the stated multiple of the Original Purchase Price, and thereafter the preferred participates with the common pro rata on an as-converted basis.

Alternative three, capped participation, is the same as alternative two except that participation stops once the preferred holders have received an aggregate of a stated multiple of the Original Purchase Price, including the amount paid under the first sentence.

Written in words, a non-participating holder receives the greater of the preference amount and the as-converted share of proceeds. A participating holder receives the preference amount plus the as-converted share of whatever remains.

Non-participating payout = max(Multiple x Invested amount, As-converted % x Proceeds)

Participating payout = (Multiple x Invested amount) + (As-converted % x Remaining proceeds)

The crossover value is the exit price at which the two branches of the non-participating formula are equal.

Crossover exit value = (Multiple x Invested amount) / As-converted ownership %

What counts as a liquidation

The definition is broader than a bankruptcy. Under the NVCA model term sheet, a merger or consolidation, other than one in which the company's stockholders retain a majority of the voting power of the surviving entity, or a sale, lease, transfer, exclusive license or other disposition of all or substantially all of the company's assets, is treated as a deemed liquidation event and triggers payment of the preference, unless a stated percentage of the preferred elects otherwise. This is why the preference governs ordinary acquisitions, not just failures.

Variants and modifiers

• The multiple. A 1x preference returns the amount invested. Higher multiples return more before common sees anything.
• Seniority. Later rounds may sit ahead of earlier rounds, or all preferred may share pari passu. This is recorded in the charter and is negotiated at each round.
• Accrued dividends. The model form allows the preference to include accrued and declared but unpaid dividends, which increases the amount paid before common.
• Escrow protection. The model form includes an optional sentence providing that the investors' entitlement to their preference is not diminished where part of the consideration is subject to escrow or indemnity holdback.

Worked example

Suppose a company has raised three rounds and is acquired for $80,000,000.

• Series C: $40,000,000 invested, 1x participating, 25 percent as-converted, senior to A and B.
• Series B: $15,000,000 invested, 1x non-participating, 20 percent as-converted.
• Series A: $5,000,000 invested, 1x non-participating, 10 percent as-converted.
• Common stock and options: 45 percent as-converted.

Step one. Series C is senior, so it takes its $40,000,000 preference first. Remaining proceeds are $40,000,000.

Step two. Series A and Series B each choose between their preference and converting to common. Test Series A: if it converts, the most it could receive is 10 percent of what is left after Series B's preference, which is 10 divided by 80 of $25,000,000, or $3,125,000. That is less than its $5,000,000 preference, so Series A takes the preference. Test Series B: if it converts, the most it could receive is 20 divided by 90 of $35,000,000, or $7,778,000, which is less than its $15,000,000 preference. Series B takes the preference too. Both preferences are paid from the remaining $40,000,000, leaving $20,000,000.

Step three. Series C participates in the remainder alongside common. Series A and Series B took their preferences, so they do not share. Among the participating holders, Series C's 25 points and common's 45 points total 70. Series C receives 25 divided by 70 of $20,000,000, or $7,143,000. Common receives 45 divided by 70 of $20,000,000, or $12,857,000.

Totals. Series C receives $47,143,000 on $40,000,000 invested, or 1.18x. Series B receives $15,000,000, or 1.0x. Series A receives $5,000,000, or 1.0x. Common, which is the founders and every employee holding options, receives $12,857,000, which is 16 percent of an $80,000,000 sale despite holding 45 percent of the company on an as-converted basis.

Note the ordering in step two. Each non-participating holder's decision depends on what the others do, because converting adds shares to the pool that splits the residual. In a stack with several non-participating series, the correct answer is found by testing the combinations, not by comparing each series against the headline exit value in isolation. All figures are hypothetical.

Where it shows up

The operative text is in the certificate of incorporation, in the article establishing the rights of the preferred stock. It appears first in the term sheet, under a heading the NVCA model form labels Liquidation Preference, sitting in the section grouped under the charter.

The deemed liquidation definition in the same clause is what makes the preference apply to a normal acquisition, and it is drafted with a carve-out for transactions in which the existing stockholders keep a majority of the voting power of the surviving entity.

The protective provisions clause is the enforcement mechanism. Under the model form, the company may not, without the written consent of the requisite holders, liquidate, dissolve or wind up its affairs or effect any deemed liquidation event, and may not create or authorise any security convertible into equity unless it ranks junior to the existing preferred. That second limb is how the seniority of an existing preference is protected against a later round trying to jump ahead of it.

The merger agreement's consideration allocation section is where the preference is actually applied at exit, usually through a payment spreadsheet derived from the charter waterfall. The model term sheet's drag-along provision reinforces this by requiring, where used, that consideration be allocated as if it were proceeds distributed to stockholders in a liquidation under the company's then-current charter.

In option grant documents and in employee communications, the preference appears only indirectly, which is the reason employees are so often surprised by it. Common stock is junior to every dollar of preference in the stack.

Common mistakes

• Reading the preference multiple without reading the participation alternative. A 1x participating preference can pay more than a 2x non-participating one at many exit values, and the NVCA model form treats both as available drafting options.
• Ignoring seniority between rounds. Whether a later series stands ahead of an earlier one changes who gets paid in a mid-size outcome and appears nowhere except the charter.
• Forgetting that accrued dividends can ride on top. Where the charter provides for a cumulative dividend payable on liquidation, the amount paid before common grows every year the company stays private.
• Comparing each non-participating series against the exit value in isolation. Whether one series converts changes the residual pool the others share, so the convert-or-take decisions have to be solved together.
• Modelling a single exit value. The preference stack behaves differently at $30,000,000, $80,000,000 and $300,000,000, and only a range shows where the cliffs are.
• Assuming an acquisition is not a liquidation. Under the model form's deemed liquidation event definition, most acquisitions are.
• Overlooking escrow. Where part of the price is held back, the model form's optional language preserves the investors' full preference, which means the holdback risk falls disproportionately on common.

Related terms

The liquidation preference is the largest term in a waterfall or distribution-waterfall and attaches to preferred-stock issued in a series-a or later round. It is negotiated on the term-sheet, sits alongside anti-dilution as the two clauses that most affect common holders, and becomes most consequential after a down-round. Its effect is only visible when modelled against a full cap-table.

Frequently asked questions

What is a 1x liquidation preference?

A 1x preference means the preferred holders are entitled to receive an amount equal to what they originally paid per share before common stockholders receive anything. The NVCA model term sheet expresses this as a multiple of the Original Purchase Price, with the multiple left as a blank to be filled in. A 1x non-participating preference is the version that returns the investment and nothing more unless converting would pay better.

What is the difference between participating and non-participating preferred?

Non-participating preferred takes either the preference or its as-converted share of the proceeds, whichever is greater, but not both. Participating preferred takes the preference and then also shares in what remains, which is why it is sometimes described as double-dipping. The NVCA model term sheet offers both as alternatives, plus a third that caps participation at a stated aggregate multiple.

Does a liquidation preference apply when a company is acquired?

Usually yes. The NVCA model term sheet defines a merger or consolidation, other than one where existing stockholders retain a majority of voting power, and a sale of all or substantially all assets, as a deemed liquidation event that triggers the preference, unless a stated percentage of preferred holders elects otherwise.

How do I calculate when the preference stops mattering?

Divide the total preference amount by the holders' as-converted ownership percentage. That gives the exit value at which converting to common pays the same as taking the preference. Above that value, non-participating holders convert and everyone shares pro rata. Below it, they take the preference and common absorbs the shortfall.

Do employees with stock options get paid before the preference?

No. Options convert into common stock, which sits behind every dollar of preference in the stack. An employee's realisable value depends on the exit price exceeding the total preference amount, which is why the same acquisition can be a good outcome for investors and a worthless one for option holders.

Can a liquidation preference be higher than 1x?

Yes. The NVCA model term sheet leaves the multiple blank in all three alternatives, so 1.5x, 2x and higher are drafting options rather than departures from the form. Higher multiples appear most often where the company has limited alternatives, and they compound with seniority and participation to push the crossover value substantially higher.

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