What is a liquidation preference?

This is one of the most important terms in a SAFE/convertible note and is often overlooked.

It provides us with a way to return some capital if the startup fails. Generally only holders of "preferred shares" get access to a liquidation preference, and holders of "common shares" so not. 

Liquidation preference outlines the order in which investors get paid and at what multiple of initial capital invested, when there is an exit. There are four parts to a liquidation preference:

Seniority structure (who receives their money first):There are 3 types of seniority structures. In a "standard structure" the investors who invested last receive their liquidation preference first. So the earliest investors lose out. In a "pari passu" every investor is treated the same and gets money back in proportion to their investment. Tiered is a mix of the two above.

Multiple:this one is easier, you will receive a multiple of your initial investment if you exercise your liquidation preference. Generally its 1x, sometimes it might be 2-3x but this can lead to resentment from other investors who don't receive this and is uncommon.

Cap:sometimes there will be a cap to your returns, this protects the founder. Usually it's a multiple of the initialinvestment.

Participation:You don't necessarily have to exercise your liquidation preference. There are two types here, non-participating liquidation preference vs full participation liquidation preference. In a non-participating liquidation preference you can either a) exercise your liquidation preference or b) convert your preferred shares to common shares. Depending on the valuation at the liquidity event, it might make sense to pick either option. A full participation liquidation preference allows you to receive your liquidation preference plus a proportion of the remaining funds divided proportionally amongst remaining common shareholders. Generally there will be a non-participation liquidation preference.

Let's go through an example, say you invested $1M for 50% of the company at a 1x liquidation preference with a 3x cap. Let's say the company exits at 10M.

If you were to exercise your liquidation preference, you would receive 3M total as you're capped at 3x your investment. In this scenario it would make sense to not exercise your liquidation preference, instead you can convert your preferred shares to common shares and receive 5M(50% of 10M). The point at which you will get paid more if you convert your preferred shares to common shares(instead of using your liquidation preference terms) is called the "conversion threshold".


Thanks for reading,

Rishad