What is a Liquidation Preference?
Although most often found in venture capital deals, liquidation preference is also used as part of hybrid debt agreements and structured private capital deals.
This type of arrangement is seen as a method for venture capitalists to protect their investment and minimize the risk of losing money on an investment.
The term can also generally refer to the order in which creditors and stakeholders are repaid when a company goes bankrupt.
The waterfall provision
A liquidation preference is referred to as the waterfall provision because it determines the order that money flows down to creditors and investors.
Because there is less risk for preferred stockholders, the potential returns of this type of investment tend to be less than with common stockholders.
Liquidation preference protects the investor from losses. The investor gets their money back before common stock investors.
Bankruptcy is not the only liquidation event that triggers this preference. The sale of a business or investment is also a viable event. Although this type of arrangement is often seen as a method of minimizing losses, having liquidation preference also means that an investor is at the front of the queue to claim their share of profits.
- Assume a business has a pre-money valuation of $10M.
- The company founders invest $5M in common stock.
- $3M of common stock is sold to investors.
- The company owes $2M in debt to creditors.
- A venture capital firm buys $1M of preferred stock with liquidation preference.
Example 1: preventing losses
If the company sells for the expected $10M, creditors receive their $2M and the venture capital investor would get all of their $1M investment back.
This leaves $7M to repay common stock holders, who would receive 7/8 of their investment back.
The preferred stockholder loses nothing, but the common stockholder loses 1/8 of their initial investment. It prevented losses for the venture capital firm.
Example 2: minimizing losses
Typically, however, venture capital investors would invest in a combination of preferred stock and common stock, so they might hold $1M in preferred stock and $1M of the common stock. Combining preferred and common stock allows the venture capital investor to achieve the level of risk and reward they desire.
In this case, if the company were to sell for $10M, credits would be repaid, leaving $8M.
The venture capital investor receives 100% of their preferred stock returns but only $875,000 of their $1M common stock investment.
Example 3: taking profit
If the company were to sell for $12M, the venture capital investor with a blended portfolio would receive their $1M preferred stock and $1.125M for their common stock.
The investor would have made double the profit if they had invested all $2M in common stock, but they ran the risk of losing more of the money if the company liquidated for less.
Multiples may be applied to the distribution preference. The examples above assume a preference multiple of 1, but a multiple of 2x could be applied. If this were the case, the venture capital investor would receive 2x their initial investment before common stockholders receive anything.
As well as being used by venture capitalists and by businesses in venture capital deals, investors in common stock should determine the amount of preferred stock before investing. If a business has a lot of preferred stock issued at 2x multiple, for example, it means that the business must be liquidated with a sizable margin before common stockholders would see a return.
Liquidation preference, most often used in venture capital funding deals, is an agreement whereby a stockholder with preference is paid out before common stockholders, in the event of any type of liquidation of the business. It can be used to protect a venture capital investment and is usually combined with an investment in common stock and acts to hedge against losses.