3 ms·

Can someone explain what a liquidation preference is?

fnazeeri 16y ago
Here's a post I wrote a while ago on how liquidation preferences work. http://www.altgate.com/blog/2008/05/how-liquidation.html http://www.altgate.com/blog/2008/05/how-liquidation.html
angelbob 16y ago
A liquidation preference, expressed as a multiple like 1x or 2x, says that the investor gets that multiple of their money back, before anybody else gets paid, on an exit (sale of the company, IPO, etc). Normally the LP is paid separately from the proceeds of common stock, so the investor also gets paid for the common stock, as well as the liquidation preference. So if the company gets sold for a small amount, the founder gets little or nothing but the investors don't lose money. If the company is sold for a large amount, the investors get an extra chunk but the founder still does very well.
- adw 16y ago
  Depends if the prefs are participating or non-participating. Most of the rounds I've heard of recently here (UK, early stage) have been non-participating.
ulf 16y ago
It means that when an exit happens, investors can have different rights to how the money is distributed. Suppose you own a company and sell 50% of it to VC X for 1 Million Dollars (2M$ valuation). The VC gets a liquidation preference, which means they will get paid before you in an exit. If you sell for more than 2 million, that is no problem. But if you sell for less, the following happens: Suppose someone wants to buy you for 1.2M$, which you agree to because you feel like the business is a dead end. According to the shares, you and the VC should get 600K$ each. But since VC x has a liquidation preference, they get their money back. So you get just 200K$ as the found. Even worse if you sell for less than 1M$, in that case you walk away empty-handed...
- amackera 16y ago
  This doesn't really seem fair...
  - byrneseyeview 16y ago
    Not really. A liquidation preference is worth something, so if you really didn't want to give on, you could give up more equity. But as Fred Wilson once pointed out, it's a great way to handle a situation where the founder thinks the company is worth way more than the VC does. If the founder is right, the VC owns less stock than they otherwise would have; if the VC is right, and the company is bought for a low valuation, the VC gets a higher percentage of the payout. Essentially, a liquidation preference can give you "conditional equity"--the founders own, say, 50% of the company if it's sold for a small amount, and 80% if it's sold for a large amount.
    - adw 16y ago
      I think you'd find a broad consensus among founders and VCs that 1x non-participating is pretty much entirely fair (and standard!) the whole time. Other pref structures often mean that either the VC had the upper hand in negotiations or that there's a big divide in valuation to cross.

Here's a post I wrote a while ago on how liquidation preferences work. http://www.altgate.com/blog/2008/05/how-liquidation.html http://www.altgate.com/blog/2008/05/how-liquidation.html

angelbob 16y ago

A liquidation preference, expressed as a multiple like 1x or 2x, says that the investor gets that multiple of their money back, before anybody else gets paid, on an exit (sale of the company, IPO, etc). Normally the LP is paid separately from the proceeds of common stock, so the investor also gets paid for the common stock, as well as the liquidation preference. So if the company gets sold for a small amount, the founder gets little or nothing but the investors don't lose money. If the company is sold for a large amount, the investors get an extra chunk but the founder still does very well.

adw 16y ago
Depends if the prefs are participating or non-participating. Most of the rounds I've heard of recently here (UK, early stage) have been non-participating.

ulf 16y ago

It means that when an exit happens, investors can have different rights to how the money is distributed. Suppose you own a company and sell 50% of it to VC X for 1 Million Dollars (2M$ valuation). The VC gets a liquidation preference, which means they will get paid before you in an exit. If you sell for more than 2 million, that is no problem. But if you sell for less, the following happens: Suppose someone wants to buy you for 1.2M$, which you agree to because you feel like the business is a dead end. According to the shares, you and the VC should get 600K$ each. But since VC x has a liquidation preference, they get their money back. So you get just 200K$ as the found. Even worse if you sell for less than 1M$, in that case you walk away empty-handed...

amackera 16y ago
This doesn't really seem fair...
- byrneseyeview 16y ago
  Not really. A liquidation preference is worth something, so if you really didn't want to give on, you could give up more equity. But as Fred Wilson once pointed out, it's a great way to handle a situation where the founder thinks the company is worth way more than the VC does. If the founder is right, the VC owns less stock than they otherwise would have; if the VC is right, and the company is bought for a low valuation, the VC gets a higher percentage of the payout. Essentially, a liquidation preference can give you "conditional equity"--the founders own, say, 50% of the company if it's sold for a small amount, and 80% if it's sold for a large amount.
  - adw 16y ago
    I think you'd find a broad consensus among founders and VCs that 1x non-participating is pretty much entirely fair (and standard!) the whole time. Other pref structures often mean that either the VC had the upper hand in negotiations or that there's a big divide in valuation to cross.