For an individual early-stage investor, the liquidation preference, colloquially “liq pref”, can be one of the more cryptic terms they can run into. It is, however, a very standard part of the venture capital risk management toolkit. As a rule of thumb, being offered a liquidation preference generally increases the attractiveness of an investment.
What is a liquidation preference?
The liquidation preference refers to an investor’s right to get his or her money back before the holders of ordinary shares. If a company is liquidated – for example as a result of it being sold or going out of business – the shareholders with liquidation preference will be the first equity holders to be paid.
The amount they will be paid is typically expressed as a multiple of the original investment. For example, in InsightsAtlas’s funding round the liquidation preference is expressed as “1x”, i.e. one time their original investment.
Why are liquidation preferences used?
Liquidation preferences are often used in early fundraising rounds to shield early investors from downside risk to their investment. Early-stage companies’ performance is hard to predict, therefore their valuations can go up and down and an eventual exit might happen at a lower valuation if the company fails to hit its goals. The liquidation preference guarantees an investor a certain payout when the company is liquidated, even if the liquidation happens at a lower valuation than expected.
Example of a liquidation preference
Let’s use this 1x liquidation preference as an example. Let’s assume that you invested and got shares with a 1x liquidation preference, however, the company failed to reach its goals and its value had dropped. If the company was later liquidated due to its sale to a strategic investor at a lower valuation, the liquidation preference would be triggered. You and other liquidation preference holders would be paid first until you recouped your original investment in full (in other words, you would be paid 1x your investment).
Note that the liquidation preference guarantees a certain payback regardless of the valuation the company is sold at. Even though the company failed to grow and had to be sold at a lower valuation, therefore forcing other investors and perhaps even founders to book losses, you still made your money back.
In a more positive scenario, if the company was sold at a higher valuation and the liquidation preference in question was a so-called non-participating, or “straight”, liquidation preference (the most common and straightforward type, also in use in InsightsAtlas’s funding round), everybody would be treated equally and be paid in proportion to the size of their share ownership.
In short, in a positive scenario the liquidation preference won’t matter. But in a negative one, it will shield you from losses. You can think of it as insurance provided by the target company.
- Liquidation preferences don’t apply to exits via IPO. When a company lists on a marketplace, all shares are generally converted to publicly tradable ordinary shares.
- If an investor had a liquidation preference of, for example, 2x, he or she would in effect be guaranteed to make a 100% profit regardless of the valuation the company was sold at. The most common liquidation preference is 1x, as its purpose is to reduce early-stage investors’ risk, not guarantee profits.
- Preferred shares are still equity, and debt is generally paid back before any equity in the event of a company going out of business. So, if you were to hold preferred shares in a company that was going out of business, the company’s debts would be paid first. If there were assets left over after the debts were repaid, then your turn would come.
- Liquidation preferences are generally honored in a reverse chronological order. Preferred shares issued in more recent funding rounds therefore receive preferential treatment relative to ones issued in older rounds.
- Companies raising funding have no obligation to offer liquidation preferences. It’s their call.