The liquidation preference is the key differentiating factor between the common and preferred share. The liquidation preference gives the preferred shareholder, typically a venture capitalist, the first priority to any proceeds upon a liquidation of the company. A pause here to understand the difference between a liquidation event and a liquidity event. You can think of a liquidation as a merger, sale, or dissolution of a business but a liquidity event also includes an initial public offering or IPO.
Upon a liquidation event the proceeds are first distributed to the preferred shareholders prior to any proceeds being distributed to the common shareholder. Not only does the liquidation preference grant the right to be in the first position upon a liquidation but the preference also specify the amount that the preferred shareholder is to receive.
As a consequence, liquidation preference rights often result in distributions between preferred and common stockholders that
disproportionately benefit preferred stockholders relative to their percentage ownership.
When we are talking about liquidation preferences we can divide them into two categories, participating and non-participating.
Nonparticipating preferred: In a liquidation, the holder of nonparticipating preferred stock is entitled only to receive the fixed liquidation preference amount and does not share any upside beyond that preference. Alternatively, the preferred stockholder may give up liquidation preference and convert into common stock if such a conversion will provide higher proceeds.
Participating preferred: In a liquidation, the holder of participating preferred stock is entitled to receive its liquidation preference first and then share pro rata with the common stock in any remaining liquidation proceeds without requiring the conversion of such preferred stock into common stock. The total return to preferred stock in this scenario may be limited (for example, three times the original purchase price of the preferred stock) or unlimited. If the upside is unlimited, the preferred stockholder will not have an incentive to voluntarily convert to common stock. If the upside is limited, the preferred stockholder may elect to convert the preferred stock to common stock if such conversionwould result in a higher total return to the stockh
Typically the liquidation preference is set as the purchase price of the preferred stock. Meaning an investor receives first what they originally put into the company. This preference of preferred stock is particularly important in a acquisition or merger situation (See the example below).
Why is the liquidation preference not important in an IPO situation?
In a IPO situation there are provisions that require the conversion of all outstanding preferred stock to common stock in the event of a qualified IPO. Such conversion is typically a prerequisite for an investment banker to market the IPO. A consequence of such conversion is that the liquidation preferences and most other special rights associated with preferred stock, with the exception of registration rights, are eliminated. Given this, the value of liquidation preferences and other preferred stock rights often diminishes as the likelihood of a qualified IPO increases.
Putting it All Together…
Here is an example (thanks to the AICPA): Company A has 3 million shares of Series A preferred stock and 7 million shares of common stock outstanding. The Series A preferred stock was issued for $20 million and carries participating liquidation preference rights with a total liquidation preference of two times the original issuance price.
That is, upon a liquidation of Company A, Series A preferred shares would initially receive $40 million of the sales proceeds before any amount of money could be distributed to common stockholders. After the payout of the initial preference, the Series A preferred and common stockholders participate ratably in the remaining proceeds of the liquidation. Assuming three different scenarios in which Company A is acquired for a purchase price of $50 million, $75 million, and $200 million, respectively, the following would be the payoffs to Series A preferred stockholders and common stockholder.