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.
After the market correction in the tech sector in the early 2000’s we saw companies that were desperate for money taking cash from “vulture” capitalists who structured deals with liquidation preferences of up to 10x, effectively wiping out the interests of previous investors by using these to capture so much of the upside for themselves. It was a difficult period, but as they say, the best time to invest is when there is proverbial “blood on the streets”. And investors with cash saw this during that time period.
But they quickly also learned that excessively 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. So why do we need liquidation preferences at all? The answer is simple; no one should make money until we are “all” making money. And as an investor, I am not “making” money until my capital has been returned. That is the primary reason why 1x liquidation preferences are very important.
Preferences also 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”, the term for shares that come with a liquidation preference. These shares are guaranteed return of their capital at a predetermined multiple (typically 1x) before founders, common shareholders or previous investors can lay claim to any of the assets of the company.
In our previous example, had you invested in Preferred Shares with a 1x 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.