What Are Liquidation Preferences and Who Gets Paid in a Sale?

A liquidation preference decides who gets paid first when a venture-backed company is sold, and how much. It is a term in the investor's preferred stock, and it is the reason a $60 million sale can leave founders with nothing.

The short version

When a company with preferred stock is sold, the preferred holders are paid according to their preference before common stockholders see a dollar. Founders and employees usually hold common. The headline price tells you what the buyer paid. The charter tells you who gets it.

How a preference works

Two terms do most of the work.

• The multiple. A 1x preference means the investor gets back what they put in. A 2x preference means twice that, ahead of common.
• Participating or not. With a non-participating preference, the investor takes the greater of their preference or their share as if they had converted to common. With a participating preference, the investor takes the preference first and then also shares in what is left. Participation is more expensive for common holders.

Seniority matters too. In a stacked structure, later rounds can be paid before earlier ones, or all series can share pari passu. The order is in the charter, not in the term sheet summary.

What the Trados case shows

In re Trados is the case founders should know. Trados, a translation software company, was sold to SDL plc in 2005 for $60 million in cash and stock. The preferred stock carried a liquidation preference of $57.9 million, including accumulated dividends. Management had a bonus plan that took the first $7.8 million of the price. That left about $52.2 million for the preferred holders. Common stockholders received nothing. Without the management plan, they would have received about $2.1 million.

A common stockholder sued. In 2013 the Delaware Court of Chancery held that the sale was entirely fair, because the court found the common stock had no economic value before the merger. In plain terms, a $60 million sale was not enough to reach common, and the court said the directors had not breached their duties by approving it.

Three things to take from it:

1. The preference is the whole conversation at modest exit prices. The lower the price relative to money raised, the more the preferred stack decides the outcome. 2. Management incentive plans can matter as much as the preference at the margin. Here the plan was 13% of the price. 3. Founders on the board are often wearing two hats, and the law does not guarantee that common holders get something.

When this bites hardest

• Down-round exits. If you raised at a 2021 valuation and are selling at a lower number, your investors' preferences may absorb most of the price. See how to think about exits below a 2021 valuation.
• Licence-and-hire deals. Where a buyer licenses technology and hires staff instead of buying the company, who gets paid depends on how the proceeds are distributed. See what happens to equity in a reverse acqui-hire.
• Distressed sales and asset sales. Proceeds go to the company first, then through the waterfall. See shut down or sell the assets.

What to do before you are in a process

1. Run the waterfall at three prices. Model what each class receives at a low, middle and high outcome. If you cannot, you are negotiating blind. 2. Read your charter, not just your cap table. Check the multiple, participation, seniority, accrued dividends and conversion terms for every series. 3. Ask about carve-outs early. A management carve-out is the standard way to keep a team motivated when the preference is large. Raise it before an offer, not after. 4. Compare offers on net proceeds to common. A higher headline with more stock or a longer earnout can be worth less to you than a lower, cleaner number.

This is general information, not legal advice. Talk to a startup lawyer before you act on your charter.

Related questions

• What is a down round and how does it affect founders?
• What happens to my equity if my startup is acquired in a down round?
• What are my options if I cannot raise my next VC round?