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ACADEMY: What is a liquidation preference?

Posted by Erica Duignan Minnihan on Jun 15, 2016 11:00:00 AM

 

A liquidation preference is an investor right that guarantees the return of investor capital before any distributions are made to common shareholders. It typically applies in every liquidation scenario except an IPO. Liquidation preferences are typically set at one times capital invested, but they can go as high as two times, three times, or more in situations where the founder is really desperate. High liquidation preferences can cause unwanted disincentives to founder performance, as it sets an unreasonably high bar for them to reach before they can participate in the profits. However it does provide the essential function of protecting investors. Here’s a simple example: If you invest $1 million into common stock in a startup at a $3 million pre-money valuation, you now own 25% of the common stock. Wonderful. But what if the following week, the founder decides to pursue his dream of living on an ashram and liquidates the company. And the only assets are the one million dollars you invested that are sitting in the bank earning 0.001% interest? Well, now you are entitled to receive $250,000 and the founders can share the remaining $750,000. Doesn’t sound fair right? This is exactly why investors typically demand Preferred Shares. These shares are guaranteed return of their capital at a predetermined multiple before founders or other investors can lay claim to any of the assets of the company. In our example, had you invested in Preferred equity with a one X liquidation preference, you would have gotten your $1 million back, and the founders would be free to head to the Ashram, with no hard feelings.

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Topics: Venture Investing Academy