Avoid Offensive Liquidation Preferences

In most equity financing rounds, an investor will ask for (and get) a term called a liquidation preference. A liquidation preference is the amount that must be paid to a preferred stock holder before any sale proceeds may be paid to the holders of common stock (i.e., founders, option holders, etc.).

The amount of the liquidation preference is usually expressed as a multiple, with the most common liquidation preference being “1X non-participating.”

This means that in the event the investor elects to use the 1x non-participating preference, the investor will receive up to 1 times the amount of the investment, but the investor will not get to participate with the common stockholders pro rata in the remainder of any sale proceeds. (Liquidation preferences that “participate” get to participate with the common after payment of the X multiple preference.)

Since an investor would only elect to use a 1x non-participating preference if the sale of the startup was for a “low” price, a liquidation preference typically is a defensive mechanism used to protect the investor’s downside.

However, 1x (or greater) participating or non-participating preferences with a multiple greater than 1 are just price negotiations, and anything better than a 1x non-participating liquidation preference is an investor offensive maneuver. The investor is maneuvering to increase returns and/or potentially blind you with a high valuation (only to be offset with a high multiple liquidation preference) so that you’ll take his or her deal.

Thus, if you see greater than a 1x preference and/or a ‘participating’ preference attached, know that your investor is just negotiating on price. If it were up to me, I’d rather have the startup and investor come to terms on the pre-money valuation rather than toying with anything other than a 1x non-participating liquidation preference.

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