Examples of Liquidation Preferences

Liquidation preferences are a common thing to see in a term sheet. Although many sites break down what liquidation preferences mean, I hardly see examples of each preference. I decided to break down the common liquidation preferences with examples for easy reference.

Liquidation Preferences

A liquidation preference is the ability for the investors to take there money out before the money left over is divided among the shareholders. This typically is a 1x (meaning the investors get their original investment back), but can be higher.

Example: The company has 100,000 outstanding shares. They previously took a $500k investment. The company sells for $5mm. The investors have a liquidation preference of 2x their investment. Since they invested $500k, they take $1mm from the $5mm sell amount. The $4mm remaining is then split among the 100,000 outstanding shares. Investors = $1m for $500k. Shareholders = $4mm.

Participation

Upon a liquidation event, the investors participate with the other shareholders. If the investors have a liquidation preference with participation they have the ability double dip at the liquidation event. An important note, there is full participation (the example below), non-participating (example above), and capped participation, meaning there is only so much the investors can take then it stops.

Example: The company has 100,000 outstanding shares. They take a $500k investment at a $2mm valuation. The investors receive 20% of the company and another 25,000 shares are issued to the investors. The company sells for $5mm. The investors have a liquidation preference of 2x their investment. Since they invested $500k, they take $1mm from the $5mm sell amount. The $4mm remaining is then split among the 125,000 outstanding shares. The extra 25,000 the investor gets to “participate in,” making each share valued at $32.00 ($4mm / 125,000). Investors = $1.8mm. Shareholders = $3.2mm.

Senior Liquidation Preference

This comes into play when a company has taken multiple series of investments. The most recent investor is senior to to the others, meaning they get there money first.

Example: The company takes a series A liquidation preference of $10m and a series B senior liquidation investment of $20m. If the company exits for $25m the series B investors take $20m, leaving only $5m for the series A investor.

Junior Liquidation Preference

The exact opposite of a senior liquidation preference. The oldest investor is more senior than the newer investor. First money in, is first money out.

Example: The company takes a series A liquidation preference of $10m and a series B junior liquidation investment of $20m. If the company exits for $25m the series A investors take $10m, leaving only $15m for the series B investor.

Pari Passu Liquidation Preference

Something which sounds complicated but isn’t. This means the series B and series A investors are “equal” to each other. They take their investments out of the company proportionally (pro-rata).

Example: The company takes a series A liquidation preference of $10m (They took 20% of the company) and a series B pari passau liquidation investment of $20m (They took 20% of the company). The company exits for $30m. Series B investor has a 2:1 investment over the A investor, so for each $2 investor B takes, investor A gets $1. Investor A: $8,333,333 Investor B: $16,666,666.

Hopefully these examples help you. Let me know if this was helpful or confusing for you.