Liquidation Preferences & Preferred Stock

To set the foundation, Stock (or equity) represents a piece of ownership in a business. Equity entitles a stockholder (or shareholder or equity holder) to a portion of the company’s current or future profits. Each company has a value at any given time, which implies a stock price (or share price). The share price might be less than a penny early on in a company’s life and if a company’s successful, it grows over time to the level you may be familiar with when you look at public stock prices. That said, share prices all depend on the number of total shares outstanding, and there are methods such as stock splits or reverse stock splits which can manipulate the price per share by increasing or decreasing the number of shares in a company.

How do you get shares in a company? You get shares by either helping to capitalize a company (with money), founding the company, or by helping to grow the company’s value (with activities like building product, making sales, or performing operations). While stock represents ownership in a business, there are different types (or classes) of stock.

Not all stock is equal. In fact, there are different classes of stock, which have different rights and share price. Common stock, or common shares, is the most basic form of equity. If you are dealing in SBC, your equity will likely be in common stock. When you exercise options or vest restricted stock, you likely receive common stock in return.

As a common stockholder, you have basic voting rights and the right to future cash flows. Preferred stock, or preferred shares, is another class of stock similar to common stock but with additional rights. As suggested in its name, preferred stock takes preference over common stock and tends to be paid out first in situations like a liquidation or payment of a dividend. Each company outlines its own set of rights to preferred and common shareholders. The rights of stockholders with preferred stock at Company A may not be the same as the rights of stockholders with preferred shares in Company B.

At private companies, you will see preferred stock commonly issued to investors. It is called preferred stock because of a common provision called a liquidation preference. Investors want to protect their paid-in capital, which is the amount they invested in the company. As a result, they will include a liquidation preference to protect their investment. In the event of a liquidation, their money is the first to be paid out. Preferred shares at venture capital-backed companies are considered more valuable than common shares because of rights such as the liquidation preference. When a company conducts a 409A valuation to get its Fair Market Value (FMV), the third party valuation firms will give preferred stock a higher share price than common stock. You can read more about FMV here.

We will explore liquidation preferences through an example.

In the simplest terms, say a company raises $10 million in one round of financing and receives preferred stock with a 1x non-participating liquidation preference. This 1x non-participating liquidation preference is a common type of liquidation preference, though pay attention to each figure and term.

In this example, let’s assume a company raises $10 million at a $10 million pre-money valuation from investors. The investors contribute $10 million to a business worth $10 million. A $10 million investment into a company worth $10 million yields a company worth $20 million after the investment closes. The $20 million post-close valuation is known as the post-money valuation. The investors now own 50% of the shares outstanding ($10 million investment divided by $20 million post-money valuation). Assuming the company only raises this one round before it exits, there are a few conclusions you can draw about the state of the company:

1. This company has $10 million of preference (or liquidation overhang) on top of the common stock. That means $10 million must be paid out to preferred shareholders before common stockholders receive any proceeds.
2. If the company sells for $10 million, all of the sale proceeds will be paid to the preferred shareholders to cover their liquidation preference. They will make a 1x return on their investment, which will be classified as a 1x Multiple On Invested Capital (MOIC). Let’s say the preferred stock had a 2x non-participating liquidation preference and the company sold for $20 million, then all $20 million of sale proceeds would go to the preferred shareholders. Now you can see how that 1x or 2x plays.
3. There is another feature of preferred stock called conversion. At any point in time, a preferred shareholder can convert their shares into common shares. Common shares, however, cannot be converted into preferred shares. If our hypothetical company sells for $100 million (remember that the preferred shares make up 50% of all shares outstanding), then the investor can choose to convert their shares into common stock before receiving its proceeds. The investor is asking themselves, would I rather generate my liquidation preference by not converting (a $10 million return or a 1x MOIC), or would I rather convert my preferred shares into common to share in those proceeds on a percentage basis, generating a $50 million return or a 5x MOIC. To get to this answer, the investor will build a waterfall. The waterfall is typically built in Microsoft Excel or Google Sheets and covers the payouts to each stockholder at every exit value if they choose to hold preferred or common stock.
4. The next piece of the liquidation preference is the participation feature. A liquidation preference will either be non-participating (what’s most common) or participating (what’s known as a participating preferred or a part pref). If a liquidation preference is non-participating, then the preferred shareholder either converts their preferred shares into common to share in the common pool proceeds at exit, or they will choose to remain a preferred shareholder, limiting the amount they can be paid back to their amount of preference.
5. The example above displays a non-participating liquidation preference. Had the liquidation preference been participating, then the preferred shareholders would have received their liquidation preference proceeds and shared in the common stock proceeds. They have two ways to make money. In the $100 million exit example with 50% of the shares being preferred, the participating preferred shareholders will make their liquidation preference of $10 million back and then will share in the remaining proceeds alongside the common stockholders (divide $90 million in half). In the end, the preferred stockholders will generate $55 million on a $10 million investment, or a 5.5x MOIC.
6. The final piece of the liquidation preference is the potential cap on a participating preferred, or a limit on the amount preferred shareholders can make. In the example above, we will change the preferred to feature a 1x participating liquidation preference with a 3x cap. All that we added was the cap. This cap means that the preferred shares can generate up to a 3x return prior to converting to common stock. In the example above at a $100 million exit, there are two scenarios. The preferred class will generate $30 million ($10 million from the liquidation preference and $20 million from the common pool) in proceeds if they do not convert. Otherwise, they will generate $50 million (50% of $100 million) if they do convert. The shareholders will choose to convert to common to maximize their gain.

This type of analysis gets complicated quickly. At many private, venture-backed companies today, you will encounter multiple classes of preferred stock due to multiple fundraising rounds. At IPO, companies may have common stock, Series A preferred stock, Series B preferred stock, Series C preferred stock, and so on. If you have a 1x non-participating liquidation preference, it is fairly clean and not overly difficult to navigate. At IPO, a company's value has likely far surpassed the amount of preference on a company, and the preferred shareholders will convert to common.

Keep in mind though, the more money that is raised, the greater the preference that must be paid back, i.e. the higher the exit value, prior to founders and employees receiving any proceeds. You can consider what happens to common shareholders when a company raises $100 million and exits for $100 million.

There are other provisions which you may see in preferred stock. These include:

• The right to appoint a board member to represent that class of preferred stock
• The right to vote alongside other preferred shareholders
• A Right Of First Refusal (ROFR) and a right of co-sale. These rights normally go together. They ensure that preferred will be first in line to participate in a share transfer, which can be either a share purchase or a share sale. A ROFR must be exercised and if there are multiple shareholders who exercise their ROFR, they will each participate on a pro-rata basis – in other words, based upon the percentage of the pool they own.
• A dividend on the preferred stock, which drives the amount of preference up by some rate each year

These are just a sample of the rights you may see in preferred stock. The breadth of these rights is why working with strong professionals on the legal side is often worth the cost. They know what is standard and non-standard and will help you understand any confusing terms. With that said, no one is perfect, and sometimes you will encounter legal docs drawn up incorrectly. It is always best to have multiple perspectives, and you can understand why having advisors and/or investors around the table can be worthwhile.

One quick aside as it relates to the public markets. The stock price you see for companies like Facebook or Salesforce is the common stock price. Most preferred stock converts to common at IPO. If a public company has preferred stock, the preferred will have its own share price which will likely be different from the common stock price. Those buying preferred stock in a public company likely do so because it has fixed dividends attached to it. However, public preferred stock likely has a capped upside, which is the exact opposite reason of why investors have preferred stock in private companies.

Investors usually choose to invest based on an outcome that allows them to convert their preferred to common. It is how they generate strong returns for their investors, or limited partners (LPs). No one is in it to make a 1x and many do not want to make even a 2x. A liquidation preference is described as a form of downside protection, which was designed to protect the capital invested in a business. All else equal, raising money and increasing your liquidation preference will shift the goalposts on what type of outcome generates proceeds for common shareholders such as founders and early employees.

Do not forget about dilution. Your percentage ownership is a function of the number of shares outstanding at any company. The number of shares outstanding will likely go up over time, which means that your percentage ownership will go down. The rationale you will hear is that despite more shares being issued, your price per share is going up. It is better to own a little bit less of a much bigger pie.

The number of shares outstanding will increase as a company grants more SBC, raises outside money, or makes acquisitions paid for with company shares. If your company raises outside capital, an investor will value your business at a certain number (the pre-money valuation), put capital on the balance sheet, and the sum of the two will yield the post-money valuation.

Any capital used to purchase shares from existing shareholders will not affect the post-money valuation as no capital is given to the company. When money is given to a company, it issues new shares and hands those over to investors. As part of a round of financing, you will also see new SBC arrangements, such as the expansion of the employee option pool. The option pool is used by your company to award SBC to future hires. You may also see companies offset any dilution in a round for a certain group of employees (typically co-founders or management).

When you first think about share prices, you will often think of public companies that have a stock price you can look up online. However, all companies have a stock price whether or not they are listed publicly. Any share price is just a function of its overall equity value and the number of shares outstanding. Debt changes things a bit, but for illustration's sake, the formula has two variables, the value of the business and the total number of shares. Dividing one by the other gets you to a price per share. Our steadfast advice is to think in terms of share price. A company may experience dilution over time. Your north star is seeing share price growth. Do not be distracted by headline valuations. Think about it this way: if you get diluted and go from owning 10% of a company to 5% of a company, your company needs to double or grow by 100% in value for your shares to be worth the same amount of money. This is how founders, employees, and existing investors should think.

You can purchase shares from existing shareholders or early investors. This process is known as buying secondary. It is called secondary because it is one degree away from the company. Investing in the company and is known as primary. The market for secondary at private companies is becoming more efficient over time, though there are still several limitations. Secondary transactions must often be authorized by the board. You do not want competitors or shady parties to acquire shares in the company and potentially certain rights.