Navigating Liquidation Preferences

An article we liked from Thought Leader Stepan Khzrtian of Corpora:

Beware the Liquidation Preference, the "Smooth Criminal"

Don't agree to anything other than 1x liquidation preference, non-participating.

TL;DR: “1x liquidation preference, non-participating.” When it comes time to raise your Series Seed round, this is the one phrase you need to remember from this entire post.

I was having lunch with a friend…

“Your counsel agreed to 3x?!”

I nearly choked on my burger. It took a gulp of coke to push the remaining bite down my tied-up throat. My founder friend’s counsel had agreed to a 3x liquidation preference for the seed round, and they found out what that actually meant after closing.

“I know, it’s unbelievable,” my friend said as he cut his chicken fillet. “We had to spend a lot of money to fix it for the next round.”

“That’s crazy. 1x, non-participating – anything other than that is unacceptable.”

“Yeah, now we know. Fortunately, it’s fixed. Never again.”

What is a “liquidation preference”?

In the plainest of terms:

a liquidation preference is your investor’s right to get their money back first, before other stockholders, when the company shuts down or is sold.

Seems like an innocent, reasonable term if you don’t know the layers involved. Fact is, it can prove to be a “problem in disguise”.

Let’s break this down.

Shutting down or selling your company

The liquidation preference kicks in when your company shuts down (aka, dissolves) or exits (for example, in a sale of assets). When this happens, the company gets proceeds which it will then use to:

First, pay off its creditors (people it owes money to, such as vendors), and
Then, pay out its stockholders.

The liquidation preference comes into play when it’s time to pay out the stockholders.

Paid first among stockholders

A liquidation preference allows the investor to “dip first” into these proceeds in order to recoup their investment. After they get paid out, whatever remains is distributed to...