A liquidation preference is a feature of preferred stock which specifies how much and the order in which a preferred stockholder is entitled to be paid from the proceeds of a sale or liquidation of a company. The specified amount is referred to as the “preference amount,” while the order in which the stockholder is to be paid is referred to as the “payment priority.”
The preference amount can vary. The preference amount is usually expressed as a multiple of the original price per share of preferred stock. When market conditions are good, as in recent years, liquidation preference multiples for preferred stock sold in Silicon Valley venture capital financings are typically one-times (1X) the original price per share. When market conditions deteriorate, or if a particular company is facing headwinds or is perceived as a riskier investment, one can expect to see higher liquidation preference multiples in these transactions.
The payment priority is expressed in relational terms, and can be senior (paid before), junior (paid after), or pari passu (paid at the same time) to the payment priority of other classes or series (i.e., types) of stock. In the sale or liquidation of a typical company, preferred stock with a liquidation preference will be paid before common stock, which is traditionally last in line for any payments.
A preferred stock liquidation preference serves as “downside protection” for investors. If a company is sold or otherwise liquidated for a low price, then having a liquidation preference means that the preferred stock investors have a right to be paid back out of any proceeds that are available, up to the preference amount, before anyone else is entitled to receive any payments. On the upside, in a successful exit scenario, another feature of preferred stock, the conversion right, allows preferred stock investors to convert their shares of preferred stock into shares of common stock in the event that the payment the investors would receive as holders of common stock exceeds the preference amount of the preferred stock.