What is Liquidity Preference?

Liquidity preference is a contractual right that specifies the manner in which an investor can be paid in case of a liquidity event in a business. Liquidity preference is usually applied to preferred stock belonging to venture capital and private equity investors.

It involves the right of preferred stock owners to get some or all of the money before the common stock shareholders do in case of any liquidity event in the business. How much an investor gets from such an event is usually determined by the provisions of the preferred stock.

How Liquidation Preference Works?

The term sheet will contain a provision called a liquidation preference, which means that when the investor purchases preferred stock, he/she is entitled to a predetermined payment that will be subtracted from the total profits made from the venture. This provision protects the interests of investors in case the sale brings lower revenue than expected.

Why Liquidation Preference is Important to Founders and Employees

• It comes before common stock on the payment scale. Founders and employees are holders of common stock (or options), and get paid only after all preferred stock liquidation preference has been accounted for.
• High multiples and stacked preferences compound. In the case of a company that has been financed through many rounds, each having its own preference, the overall liquidation preference “overhang” takes up a substantial part of an already limited exit value.
• It influences negotiations in future financing rounds. The worse conditions early investors have, the worse conditions later investors will ask for, or even better.
• It determines exit motivations. At times, a marginal exit decision could result in a huge difference between exit values for preferred and common shareholders.

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