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Preferred Share Liquidation Preference
A liquidation preference for preferred shares allows the investor priority in recuperating her investment if the company is sold or undergoes some other exit event. A liquidation preference is a security measure to mitigate the investor’s risk of financial loss as compared to other shareholders (the entrepreneur). Basically, the investor gets paid ahead of other shareholders. The liquidation preference often goes beyond simply assuring a return of the investor’s funds – it may return some multiple of the initial investment. This means the investor will get some multiple of their invested capital (2x, 3x, 5x, etc.) if the company goes through an exit event. This is the primary method by which investors are compensated. While generally understood to mitigate risk for the investor and shift that risk onto the entrepreneur, a liquidation preference protects against opportunism by the entrepreneur in seeking an exit event that does not benefit the investor.
Liquidation Preference and Conversion Rights
Liquidation preferences are closely connected with conversion rights. Generally, an investor will not convert preferred shares to common shares when the value of the common shares is less than the liquidation preference amount. Conversely, if the value of the preferred shares when converted to common stock exceeds the liquidation preference, then there is an incentive to convert the shares. The liquidation preference protects the investor against early exits that fail to capture the anticipated value of the business venture by allowing the investor to be compensated (or receive a return on capital) before the entrepreneur receives any funds from the exit event.