What it means
A liquidation preference is the right of preferred stockholders to be paid before common stockholders when the company is sold, merged or wound up. The charter usually treats a sale of the company as a liquidation for this purpose, so this is about exits, not just shutdowns.
The most common term in US venture rounds is a 1x non-participating preference: preferred receives the greater of what it invested, plus any declared but unpaid dividends, and what it would receive had it converted to common.
Non-participating preferred takes its preference or converts, never both. It converts when its ownership share of the proceeds is worth more than the preference, so above a certain sale price the preference stops mattering.
Participating preferred takes its preference and then also shares in what's left as if converted. A cap limits its total to a multiple of what it invested, and above that point it converts instead. Multiples above 1x appear more often in difficult markets.
With several series, the charter sets the order. Senior series are paid in full before junior ones; pari passu series are paid side by side, pro rata to their preferences.
Preferred invested $10 million for 25% of the company. In a $30 million sale, converting would pay it $7.5 million, so it keeps its $10 million preference and common shares $20 million. If the preferred were fully participating, it would take $10 million plus 25% of the remaining $20 million, $15 million in all, leaving common $15 million. Above a $40 million sale, the non-participating preferred converts.
Why it matters. At a modest exit the preference decides what founders and employees receive. In a $30 million sale with $10 million of 1x non-participating preferred that takes its preference rather than converting, common shares the other $20 million; participating preferred would take more of it.
Try it with your numbers
Change any number. The working below updates as you type.
Preferred = greater of (Preference [+ participation]) and Ownership × Proceeds · Common = Proceeds − PreferredWhat stockholders receive, after debt and fees.
1x is the norm.
Total to preferred, as a multiple of what it invested. Capped only.
To common
$20,000,000.00
How it’s worked out
- 1Preference$10,000,000.00 × 1x, limited to $30,000,000.00$10,000,000.00
- 2If preferred converts to common25.0% × $30,000,000.00$7,500,000.00
- 3To preferredKeeping the preference pays at least as much$10,000,000.00
- 4To common$30,000,000.00 − $10,000,000.00$20,000,000.00
- 5Exit value above which preferred converts$10,000,000.00 ÷ 25.0%$40,000,000.00
One class of preferred and common only, with no declared dividends, debt, transaction fees or management carve-out. With several series, the charter decides whether they're paid one after another (senior first) or side by side (pari passu, pro rata to their preferences). Common here includes founders, employees' exercised options and anyone else as converted. Your certificate of incorporation is the authority.
The entry, worked
A company sells $10,000,000 of Series A preferred with a 1x non-participating liquidation preference and pays $50,000 of legal fees for the round.
| Account | Debit | Credit |
|---|---|---|
| Cash | $9,950,000.00 | |
| Series A preferred stock | $9,950,000.00 | |
| Total | $9,950,000.00 | $9,950,000.00 |
Preferred is recorded at the cash received, net of issuance costs. The $10,000,000 preference is disclosed in the notes, not booked as a liability.
Common questions
Is a liquidation preference a liability on the balance sheet?
Usually not. The preference is a right on a sale or liquidation, not a promise to repay, so preferred stays in equity and the terms are disclosed. Where a sale could force a cash payout to preferred, SEC registrants present it outside permanent equity, and many private companies do the same.
What happens with more than one series of preferred?
Each series' preference is paid in the order the charter sets. Later series are often senior; pari passu means all series share pro rata until their preferences are met.
Does the preference affect our 409A valuation?
Yes, indirectly. A 409A allocates the company's value between preferred and common, and the preferences sitting above common are one reason common is valued below the preferred price.
Where it comes up
The glossary entries, founder guides and lessons on this site that use the term and link here.
- EquityThe residual interest in the assets that remains after deducting liabilities (FASB CON 8 ¶E61)Glossary
- The accounting equationAssets = liabilities + equity is not a formula you apply at period end. It is true after every single entry, and that is what makes the books provable.Lesson 2
- Accounts, and the five typesEvery account belongs to exactly one of five types, and its type decides which side increases it. Get the type right and the entry writes itself.Lesson 3
- The balance sheetThe other three account types, at one instant — and the single line where the month's profit lands, which is what ties the two statements together.Lesson 11
Read further
General information for US companies, not tax, legal or accounting advice. Check the specifics with a CPA before you act on them.