Definition of Liquidation Preference

Liquidation preferences are contractual provisions used to specify the order in which proceeds are distributed (and how much is distributed) when a startup is sold, undergoes a merger, or faces liquidation. They're particularly relevant for preferred stockholders, such as venture capitalists (VCs) and other institutional investors. These preferences dictate how the pie is split among different shareholders in a liquidity event.

Here's a breakdown of liquidation preferences:

1. Purpose:
   • The primary reason for liquidation preferences is to provide downside protection for investors. When VCs invest in a startup, they're taking a significant risk. Liquidation preferences ensure that, in the case of an exit or sale, they get their money back before other stakeholders.
2. Types:
   • Non-Participating Preferred: Once preferred shareholders receive their liquidation preference, the remaining proceeds are distributed among the common stockholders. The preferred stockholders don't "participate" further in the proceeds. 
   • Participating Preferred: After preferred shareholders get their liquidation preference, they also "participate" in the remaining proceeds with common stockholders, essentially getting a double-dip.
   • Capped Participating Preferred: This is a variation of the participating preferred, where the preferred shareholders can participate but only up to a certain limit or "cap."
3. The "Multiple":
   • The multiple defines how much preferred stockholders receive before the remaining shareholders. A common multiple is "1x", which means that, in a liquidity event, preferred stockholders receive their initial investment back before any proceeds are distributed to other shareholders. However, in some deals, this can be 2x or more.
4. Example:
   • Imagine a VC invests $1 million into a startup at a 1x liquidation preference and non-participating. If the company is later sold for $10 million, the VC would first get their $1 million back. The remaining $9 million would then be distributed among the other shareholders based on their equity stakes.

Liquidation preferences can become contentious because they influence who gets what in an exit. While they provide protection for investors, excessive or complex liquidation preferences can be detrimental to founders and employees as they may significantly reduce their share in a modest exit. Given this, the terms are usually a significant point of negotiation in funding rounds.