Whether you are a founder or employee at a startup, you are likely compensated in common stock. But what’s the difference between your common stock and the preferred stock that investors typically receive? Answer: investor-friendly terms.
A liquidation preference simply means that upon a liquidity event, better known as an acquisition, merger, or IPO, the preferred stock is paid out first. Only after the preferred stock is fully recouped will the common stock see a penny. Because of this, there is often a very real danger of the common stock seeing nothing from a liquidity event.
For example, VCFirm invests $30 million in Fundco in exchange for preferred stock. Fundco is bought for $80 million. VCFirm’s preferred stock will have preference over the common stock and get paid out first, so the common stock will only get $50 million of the total acquisition price.
Conversely, if Fundco were bought out for only $20 million, then VCFirm would receive $20 million, and the common stock would be left wanting.
Liquidation Preference Multiple
In the case of VCFirm and Fundco, VCFirm only recoups what it has invested and hasn’t actually profited from its investment – not exactly the definition of return on investment.
From VCFirm’s perspective, this problem is solved with the liquidation preference multiple, such as 2x or 3x. This means that VCFirm’s preferred stock will be entitled to two times, or three times their initial investment before common stock sees a penny.
For example, VCFirm invests $30 million in Fundco in exchange for preferred stock. Fundco is bought for $80 million. VCFirm now institutes a 2x liquidation preference multiple. VCFirm will receive $60 million because it is two times the amount of their initial investment, leaving the common stock with only $20 million.
Participation is a provision that essentially allows VCFirm’s preferred stock to get paid twice.
First, VCFirm will be able to first get paid via the liquidation preference of preferred stock.
Next, VCFirm’s preferred stock will be added to the common stock pool, and split the remaining money with them.
For example, VCFirm invests $30 million Fundco in exchange for preferred Stock. Fundco is bought for $80 million. VCFirm institutes a 2x liquidation preference multiple, and also a participation provision. VCFirm will first receive $60 million, then split the remaining $20 million with the common stock.