Software Growth

Liquidation preference

Liquidation preference decides who gets paid first, and how much, when a company is sold or wound up. Preferred investors are paid before common holders.

A liquidation preference is a clause in preferred stock that lets investors recover their money before common shareholders (usually founders and employees) get anything when the company is sold or liquidated. It does not matter in a huge outcome. It matters a lot in a modest sale, which is exactly where many SaaS exits land.

The two common types

  • 1x non-participating. The investor chooses the greater of (a) getting their money back, or (b) converting to common and taking their percentage. They cannot take both.
  • Participating. The investor first takes their money back, then also shares in the remainder alongside common holders, so they are paid twice.

The multiple (1x, 2x) says how many times the investment comes back first. The book Venture Deals by Brad Feld and Jason Mendelson lists liquidation preference among the core economic terms of a term sheet. The 1x non-participating version is generally described as the founder-friendly standard, while participating and multiple-x versions are more investor-friendly.

Worked example

An investor puts in $2M for 20 percent. The preference is 1x.

  • Exit at $6M, non-participating. Preference is $2M; converting would give 20% x $6M = $1.2M. The investor takes $2M and common gets $4M.
  • Exit at $6M, participating. Investor gets $2M + 20% x ($6M - $2M) = $2.8M. Common gets $3.2M.
  • Exit at $20M, non-participating. Converting gives $4M, which beats $2M. Investor takes $4M, common gets $16M.
  • Exit at $20M, participating. Investor gets $2M + 20% x $18M = $5.6M. Common gets $14.4M.

Stacking

Each round adds a preference. Later investors are often paid first (senior) or equally (pari passu). Several rounds of preference can leave common holders with little in a sale below the total raised. That is a central reason founders who plan a small exit should think hard before raising venture money.

SAFEs also convert into a form of preferred stock, so check what preference the converted shares carry. This is general information, not legal advice.

Sources

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