The liquidation preference is the amount that must be paid to the preferred stock holders before distributions may be made to common stock holders. The liquidation preference is payable on either a liquidation of the company, asset sale, merger, consolidation or any other reorganization resulting in the change of control of the startup.
It is usually expressed as a percentage of the original purchase price of the preferred, such as “2x.” Thus, if the purchase price of the preferred is $5 per share, a liquidation preference of 2x will be $10 per share.
Alternatively, the liquidation preference can expressed as a per share amount, as seen in this generic liquidation preference clause:
The holders of the Series A Preferred Stock shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Corporation to the holders of the Common Stock by reason of their ownership thereof, the amount of $10 per share (as adjusted for any stock dividends, combinations or splits with respect to such shares) plus all declared or accumulated but unpaid dividends on such share for each share of Series A Preferred Stock then held by them.
Let’s take a simple scenario to see how the math works:
(1) Series A Price = $5 per share
(2) Series A Shares = 500,000
(3) Series A Equity Stake = 33% (i.e., they are investing at a $5MM pre-money valution)
(3) Series A Liquidation Preference = 2x (i.e., $10 per Series A share) = $5,000,000
(4) Startup Company is sold for $6,000,000
While the Series A investors paid $2,500,000 total for their shares for 33% of the startup company, the 2x liquidation preference will ensure that the Series A investors receive $5,000,000 of the $6,000,00 purchase price of the startup. Thus in this scenario, the 2x liquidation preference gives the Series A investors 83.3% of the total sales price of the startup (even though the Series A equity stake is 33%) and the common stock holders will receive the remaining 16.7% pro-rata in accordance with their common stock ownership.
(This example assumes that the Series A preferred shares do not participate with the common in the remaining 16.7%. I’m also leaving out the possibility of conversion-to-common to simplify this example.)