Liquidation preference, explained with numbers

What is a liquidation preference?

A liquidation preference is a clause that puts an investor first in line when a startup's value is paid out. It applies in a 'liquidation event': a sale of the company, a merger, or a winding up. The investor gets a set amount before common shareholders, who are usually the founders and employees holding stock options, receive anything.

The idea is simple. An investor who puts in ₹20 crore wants some protection if the company sells for much less than hoped. The preference says: pay me back first, then share what is left. In India, investors normally hold preference shares, often compulsorily convertible preference shares (CCPS), and the preference is written into the shareholders' agreement and the company's articles of association.

What does 1x mean?

The multiple tells you how many times the original investment the investor can take back first. A 1x preference means one times the money invested. If an investor put in ₹20 crore, the first ₹20 crore of sale proceeds go to that investor. A 2x preference would mean ₹40 crore first.

Most venture deals in India use 1x. Higher multiples, such as 1.5x or 2x, appear mainly when the company is in a weak bargaining position, for example when it is raising a rescue round. A founder reading a term sheet should check the multiple early, because every extra turn of the multiple moves money from the common shareholders to the investor in a modest exit.

What is the difference between participating and non-participating?

This is the clause that changes the maths most. With a non-participating preference, the investor chooses one of two things: take the preference amount, or convert to ordinary shares and take their percentage of the sale. They take whichever is larger, not both.

With a participating preference, the investor takes the preference amount first and then also shares in what is left, as if they had converted. This is sometimes called double dipping. Participating terms are more favourable to investors and are less common in healthy rounds. A middle path is 'capped participation': the investor participates until total proceeds reach a limit, such as three times the investment, and then it stops.

How does a liquidation preference work in a real exit?

A preference only changes the result when the sale price is below a certain point. At a high price, a non-participating investor converts to ordinary shares because their percentage is worth more than the preference. The preference is then unused. At a low price, the preference is worth more than the percentage, so the investor takes it.

The worked example below shows both cases. The break-even point is easy to find: divide the amount invested by the investor's ownership percentage. If the investor put in ₹20 crore for 20 per cent, the break-even sale price is ₹100 crore. Below it, the preference matters. Above it, a non-participating investor simply converts.

Many people find the break-even idea easier with a second example. If an investor puts in ₹5 crore for 10 per cent, the company is valued at ₹50 crore after the money. Below a sale price of ₹50 crore, a 1x non-participating investor takes the ₹5 crore preference. Above it, the investor converts and takes 10 per cent of whatever price is paid.

Does the preference change from round to round?

Yes, each round can bring its own terms. A seed round may carry a simple 1x non-participating preference, while a later round led by a growth investor may ask for something stronger because the cheque is larger and the investor wants more protection. The terms of each series are written separately, so a company with four rounds can have four different sets of rights.

This is why a cap table alone does not tell you who gets what in a sale. You need the preference terms next to it. Investors and founders often build a simple table, called a waterfall, that shows how a given sale price flows to each class of shareholder. Running that table at several sale prices, such as one half, one and two times the last valuation, shows quickly whether the terms are balanced or lopsided.

What is the order of payment between rounds?

When a company has raised several rounds, the preferences of different series need a ranking. There are two common ways. In a 'standard' or 'pari passu' structure, all preferred investors share the money in proportion to what they put in, so nobody is ahead of the others. In a 'stacked' or 'senior' structure, the latest round gets paid first, then the one before, and so on.

Stacking hurts earlier investors and founders more in a weak sale. Before any of this, the company's debts are paid. Banks, lenders and other creditors, as well as employee dues and taxes, rank ahead of shareholders under the law. Preference shareholders only get what remains after creditors, and only up to what is left.

Why do founders and employees care?

Founders and employees are usually common shareholders, so they are paid last. A company can be sold for a headline price that sounds large and still leave the team with little, because preferences, debts and fees come out first. This is one reason a 'successful' sale can disappoint those who did the work.

Employees holding stock options should ask how many preferred shares sit ahead of them and what the multiple is. Founders can negotiate: ask for 1x non-participating, ask for pari passu ranking between series, and be careful about accepting a higher multiple in exchange for a better headline valuation. A higher valuation with heavy preferences can be worth less to the common shareholders than a lower valuation with clean terms.

What happens to employee stock options in a sale?

Employees hold options, which are rights to buy shares at a fixed price called the exercise price. In a sale, an option is worth only what the common share receives minus the exercise price. If the preferences swallow most of the proceeds, the common share may receive little, and options with a high exercise price can end up worth nothing.

This is the point where a high headline valuation can mislead. A startup that raised at a high valuation with heavy preferences needs a much bigger exit before the common shares are worth much. Employees joining a late-stage company should ask what the company would need to sell for before their options pay out, and a good employer will help them understand the answer.

What should you check in your own deal?

Read the definition of a liquidation event. Some agreements treat a sale of most of the company's assets, or even a merger where shareholders keep their stake, as a trigger. Check whether the preference includes unpaid dividends, which would raise the amount owed. Check whether it converts automatically at an IPO, which is the usual case, so that the preference falls away when the company lists.

Read the clause on how proceeds are split once preferences are paid. Look for a cap on participation. Look at who holds a veto over a sale below a certain price. These details are negotiated, not fixed, and Indian law leaves much to the contract. This guide is general information. Check with a lawyer or chartered accountant before signing anything.

Read next

• The term sheet, clause by clause
• What is a cap table?
• Dilution: why founders own less after every round
• CCPS and CCDs: the instruments behind most Indian rounds
• What is a down round?