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Investors in a startup venture want to make certain that they will receive a return of their money invested before the entrepreneur receives any funds for the sale of the business venture, merger, liquidation, or public offering. Investors achieve this desire by incorporating a liquidation preference into the preferred class of share. Commonly, investors will negotiate to receive some multiple (2x, 3x, 4x, etc.) of their money invested, before other shareholders receive any of the proceeds from the business exit event. The liquidation preference is used to minimize the risk of loss to the investor above that of other non-preferred, shareholders. The business venture has to perform very well for non-preferred shareholders to receive any return. This serves as a control mechanism to prevent the entrepreneur (or common shareholders) from seeking an early exit that does not produce a return or ample return for the investor. You commonly see a multiple liquidation preference when the investment is in a risky venture or the startup is having difficulty in raising funds otherwise. The key attributes of preferred stock liquidation preference is as follows:
- The amount of the preference (represented as a multiple of amount invested);
- The priority of payment of proceeds (E.g., series B, Series A, then common shareholders);
- Participation rights of preferred shareholders after receiving the entitled liquidation preference.
The liquidation preference can be far more important to the investor than the valuation of the firm. For example, if an investor receives 5x money invested (without subsequent participation rights), it does not matter if she owns 1% or 99% of the business for purposes of return. After receiving the 5x preference, all of the rest of the funds go to the common shareholders.
The liquidation preference is also extremely useful in creating a higher value class of preferred shares in comparison to the low market value of the common shares. This can allow for more flexibility in the award of shares and options as employee incentives.