Liquidation preference

A liquidation preference decides who is paid first, and how much, when a company is sold or wound up. The headline valuation of a round tells you the price of the shares. The preference tells you what happens to each pound of a sale, and the two can give very different answers.

In a strong exit the preference barely matters, because investors would convert to ordinary shares and take their ownership share. In a modest or poor exit it can take most of the proceeds, and founders and employees holding ordinary shares are paid after it.

Because every later round usually adds its own preference on top, the total sitting ahead of the founders grows with each raise. It is worth modelling before signing a term sheet, not after.

• Read the preference on a term sheet before looking at the headline valuation.
• Treat one times, non-participating as the standard to aim for, and negotiate hard over a higher multiple or participation.
• Model several exit prices in a spreadsheet against the actual terms, not only the best case.
• Check the order of payment. In a stacked structure, the latest investor is paid first, then the one before.

When a company is sold, the buyer's money does not simply split by ownership. Investors who bought preferred shares usually have a clause saying they are paid a set amount first. That amount is normally a multiple of what they invested, called the preference. Whatever is left is then shared among the other shareholders.

Two details change the outcome. The multiple is how many times the investment comes back first, most often one times. Participation decides whether the investor also shares in the rest. With a non-participating preference, the investor takes either the preference or their ownership share, whichever is larger. With a participating preference, they take the preference and then their share of what remains.

• Comparing offers on valuation alone and never reading the preference clause.
• Accepting participation without modelling it. A participating preference pays the investor twice, once as a preference and again as a shareholder.
• Looking only at the best-case exit. The clause matters most in the modest ones, so model at least three prices.
• Forgetting that preferences stack. Later rounds may rank ahead of earlier ones, and each adds to the total paid first.
• Overlooking how debt and fees come off the sale price before any shareholder is paid.