It doesn’t matter if you are a venture capitalist or a business owner, if you are in the business of businesses, you may have come in contact with the term Liquidation Preferences. If you are not aware about what liquidation preferences are, this article is going to explain about what are liquidation preferences and what do they mean for a business. This article also covers the different types of liquidation preferences which are important to know about if you are a business owner or are looking to invest in a business.

What Are Liquidation Preferences?

A liquidation preference is an arrangement intended to fill in as assurance for the financiers of an organisation if that organization exits at a value lower than what was at first anticipated in the market.

To delineate how it functions, let us see how legalese describes Liquidation Preferences-

In case of any Liquidation Event, either deliberate or automatic, the holders of every arrangement of Preferred Stock will be qualified for get out of the returns or resources of this company accessible for dissemination to its investors (the “Returns”), earlier and in preference to any circulation of the Proceeds to the holders of Common Stock.

Use Of Liquidation Preferences

Liquidation preferences are put in place by investors of a company so that when the company goes into the process of voluntary liquidation, the investors who possess preferred stock of the company receive their share of the value generated by the liquidation of the company assets before the people with common shares like the company employees or even the founder of the company.

Scope Of Liquidation Preferences

Liquidation preferences are only given to the shares of the company that are purchased by the investors during the different rounds of investment. It is also important to note that the liquidation preferences are put to use only at the time that a company is exiting through the means of Mergers and acquisitions or when the company assets are liquidated due to bankruptcy or when the company owners decide to recapitalize. However, during the process of a public exit, the liquidation preferences have no value as during a public exit, all of the preferred stock of the company automatically becomes common shares during an Initial Public Offering which does not have liquidation preferences.

Features Of Liquidation Preferences

The Multiple

The multiple decides the sum a preferred shareholder must be paid back before the normal investors begin accepting any outstanding profits. A one times liquidation preference implies that if a preferred stock holder has a million dollar worth of preferred stocks of that particular organization, then the preferred stock holder should be paid back at least a million dollars before any regular investors are paid anything.

If it is the case that the organization was sold for $1.5M, the preferred stockholder would be ensured at any rate to be given a million dollars no matter what your value possession is. If it is the case that this organization was sold for only $900,000, you would be ensured the whole of this money will be given to the preferred stock holder, in light of the fact that $900,000 falls under their ensured $1M in liquidation preference.

For a two times multiple, you will be paid back $2M (regardless of just submitting $1M) before basic investors are paid anything. Multiples are commonly 1– 2x yet relying upon the economic situations of the organisation, they can be as high as 10x. If you are the owner of a business, you clearly need to agree on the most minimal vale of the multiple so that the preferred stockholders don’t get all of the value of the company upon an exit.

Participating And Non-Participating Liquidation Preferences

There are two kinds of liquidation preferences, participating liquidation preferences as well as non participating liquidation preferences.

Non participating liquidation preferences: Under this sort of liquidation preferences, the preferred stock holder has two options which are to either 1) practice his/her liquidation preferences or 2) convert their preferred stocks into common stocks and be paid an extent of the returns dependent on their value in the responsibility for that organization. Generally, the conversion rates of preferred to common stock is one to one but if you are converting your stocks then you must go through the terms to not get a lower value in common stock.

Participating liquidation preferences: In a different way then the non participating liquidation preferences, for the participating liquidation preferences, when the speculator has been paid back his/her liquidation preference, they will get an extra “participation” in the rest of the returns to the extent of their possession of the company. Suppose if the participating liquidation preference holder has put a million dollars into an organization with a one times multiple taking an interest liquidation preference in return for 20% possession. If during an exit, the organization was sold for two million dollars, then the participating liquidation preference holder would be ensured their initial investment of a million dollars, and after that an extra 20% of the rest of the returns. 20% of the remaining $1M would compare to an extra $200,000 payout, creating an all out payout of $1.2M.