Liquidation Preference
IntermediateA liquidation preference is a right, usually held by investors with preferred shares, to be paid a set amount before ordinary shareholders when a company is sold, wound up or has another liquidity event.
Liquidation preferences are common in venture capital and private equity investments. They protect investors by ensuring they get their money back, or a multiple of it, before founders and employees with ordinary shares receive anything.
A 1x liquidation preference means the investor receives at least the amount they invested. A 2x preference means they receive twice their investment first. Preferences may be non-participating, where the investor chooses either the preference amount or their share of proceeds as if they had converted to ordinary shares, whichever is higher, or participating, where they receive the preference and then also share in the remaining proceeds.
For example, an investor puts 5 million into a start-up for 25% of the company, with a 1x non-participating liquidation preference. If the company is sold for 8 million, the investor's 25% share would be only 2 million, so they take their 5 million preference instead, leaving 3 million for everyone else. If the company is sold for 40 million, they take their 25% share of 10 million instead.
Liquidation preferences can significantly affect how much founders and employees receive in a sale, especially when a company is sold for less than expected.
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