Investors purchasing preferred stock, usually demand to have a liquidity preference mechanism, whereby their purchased stock is being cashed out on preferred terms, in the event of an M&A, or liquidation of the Company.
Preference provisions serve as a hybrid mechanism, combining equity and debt concepts. Although preferred shares are, at the end of the day, classified as equity, the liquidation preference allows shareholders to cash-out first and in preference over equity issue in the past, similarly to how debt works (new debt is usually senior to older debt).
A liquidation preference mechanism comes into operation in the event of any liquidation, deemed liquidation (an M&A), dissolution or winding up of the company. In all these scenarios, proceeds are generated and distributed among different stockholders and creditors according to a waterfall dictated by the company’s governing documents.
By virtue of liquidation preference, the preferred stockholders are entitled to receive their portion of the proceeds prior and in preference to the holders of common stock (employees and founders), and junior preferred stock, usually representing money invested in the company in prior financing rounds.
Liquidation preferences are generally expressed as a multiple of the investment amount, or as a principal (the investment amount) and interest accruing on this principal over time, from the investment date and until the liquidation event occurs. Multiples and accruing interest, vary based on the existing market terms when funding occurs, or on the risks involved in investing in a company. More than often, high multiples are used when investing in distressed companies, to reflect the high risk the investor believes exists.
These days, liquidation preference multiples are most commonly set at non-participating 1x, which implies that the preferred stockholders are entitled to recover their initial investment amount in preference, or to participate and share the proceeds with the other stockholders based on the pro-rata share in the company, whichever option yielding better results from them.
The non-participating liquidation preference mechanism hedge the preferred stockholders investment when the company exits at a value lower than expected, but yet allows them to enjoy the upside if the exit yields good results.
As generally explained above, there are two different types of liquidation preferences and each of them has a significant impact on investors’ potential return. Non-participating liquidation preference entitles the preferred stockholder to the higher of:
(1) the preferential liquidation payment along with accrued dividend (if applicable), and sometimes interest, if any and not get any share in remaining proceeds, or
(2) the share in the total proceeds in proportion to percentage ownership after converting all preferred stock to common stock.
In contrast, participating liquidation preference entitles the preferred stockholders to get the investment amount (liquidation preference) along with accrued dividend (if applicable), and sometimes interest, and then they will also receive a share in additional proceeds with the other classes, on an as-converted basis.
Thus, the underlying difference between the two is that the participating preferred stockholders have a right to receive a share in remaining proceeds on an as-converted to common stock basis. Whereas the non-participating stockholders have a choice to choose between recouping their money through their liquidation preference, or receiving the amount they would be entitled to get if they converted to common stock. It is evident from the investor’s point of view that participating preferred stock is more favorable because it allows them to enjoy greater returns.
As already mentioned, it is evident that participating liquidation preference is more beneficial for preferred stockholders and less favorable for the founders of the company, and to holders of junior stock. To cure this disparity the cap on participating preferred stock may be introduced. This allows the company to limit the maximum amount that is payable to preferred stockholders. They are often set as multiple of the initial investment at 2x or 3x. By operation of this clause, the preferred stockholders are first entitled to receive the investment amount and then to get a share in the remaining proceeds in proportion to their percentage ownership in the company until the cap is reached.
From the above discussion, it can be concluded that liquidation preference serves an important purpose for the preferred stakeholders, and it helps them downsize their risk. On several occasions, this clause is specifically demanded by the investors such as venture capital firms to secure their initial investment, and in such scenarios, the founders should understand the consequences of participating as well as non-participating preferred stock.
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