Liquidation Preferences and Preferred Stock, Explained

What preferred stock is

A venture fund does not buy the same shares the founders hold. It buys a new class, preferred stock, in a separate series for each round: Seed Preferred, Series A Preferred and so on. Preferred carries the same upside as common through the right to convert into it, plus rights the common does not have. The economic ones are a liquidation preference and anti-dilution protection; the control ones are protective provisions and a board seat.

The liquidation preference is the right to receive a stated amount from the proceeds of a sale or wind-up before the common holders receive anything. The amount is a multiple of the money invested, and 1x is the norm. Whether the holder then also shares in what is left is participation. Whether one series is paid before another is seniority. Those three settings, multiple, participation and seniority, are the whole of the term.

The worked company

A fund invests $5,000,000 at a $25,000,000 post-money valuation, so it holds 20% of the company as-converted, beside 10,000,000 shares held by the founders and employees. Everything below runs that one cheque through four exit values: $10m, $30m, $60m and $100m. The exit waterfall lab opens on exactly this company, so every number here can be moved.

Non-participating: the money back or the fraction, never both

With a 1x non-participating preference the fund chooses, at exit, between $5m and 20% of the proceeds. At a $10m sale the fraction is $2m, so it takes the $5m and the founders share the other $5m. At a $30m sale the fraction is $6m, so it converts to common, takes $6m, and the founders share $24m. The crossover is where the fraction equals the preference: $5m divided by 20%, which is $25m.

Between $5m and $25m the fund receives exactly $5m whatever the price. Founders call that range the dead zone, and it matters for a reason that has nothing to do with arithmetic: the investor sitting on the board, who often decides whether a sale happens, has no financial reason inside that range to hold out for a higher price. Every extra dollar goes to the common.

Participating: the money back and then the fraction as well

A participating preferred takes its $5m first and then shares pro rata in what is left, as if it had converted. At a $30m sale that is $5m plus 20% of $25m, or $10m, against $6m non-participating. There is no choice to make because both is always more than either, and the founders call it double-dipping.

Most participating preferred is capped, commonly at a total of three times the money invested. Below the cap the holder takes preference plus participation; once the total reaches $15m it is held there; and once the fraction alone would pay more than $15m, at a $75m sale, the holder converts and gives up the preference. Between $55m, where the cap bites, and $75m, the holder is paid $15m flat: a second dead zone, further out.

Multiples above 1x, and what they signal

A 2x preference doubles the amount that comes back first: $10m on the same cheque, with the crossover pushed out to $50m, so the fund keeps its preference at a $30m sale and the founders share $20m rather than $24m. Multiples above 1x are uncommon in ordinary rounds and appear when the company is weak, the market is weak, or the negotiation was: down rounds, rescue financings and some late-stage deals in a difficult year. Their presence on a cap table says something about how the company got there, and a candidate reading one should say so.

The standard, 1x non-participating with no multiple, is standard for a good reason. It protects the investor in a poor outcome and gives them the same upside as the founders in a good one, which aligns everyone above the crossover. Every departure from it moves value from the common to the preferred in the middle outcomes, and the middle outcomes are the most likely ones.

Seniority: what happens when two rounds stack

Real companies have several series, and the question of who is paid first is a term of its own. Take a seed round of $2m at a $10m post-money (20%) and a Series A of $8m at a $40m post-money (20% of what then existed), both 1x non-participating, and a $30m sale.

With standard, or stacked, seniority the Series A is paid first. Its fraction of $30m would be $6m and its preference is $8m, so it takes the $8m. The seed then looks at what is left, $22m: its preference is $2m and its fraction of the remainder, 2.5m shares out of 12.5m, is $4.4m, so it converts and takes $4.4m. The founders and employees share $17.6m.

At a $9m sale the difference between the two seniority terms appears. Stacked: the Series A takes $8m, the seed takes the last $1m of its $2m, the founders take nothing. Pari passu: the two preferences, $10m in all, share the $9m in proportion, $7.2m to the A and $1.8m to the seed. Seed investors ask for pari passu because the alternative puts their outcome in the hands of a term the next round negotiates without them; later rounds resist it for the same reason.

The instruments that have not converted yet

A SAFE or a convertible note that is still outstanding when the company is sold behaves like a preferred share for the purposes of the exit. A post-money SAFE pays the greater of the money back and the fraction its cap implies, which is a 1x non-participating preference by another name. A convertible note is debt until it converts, so it takes principal plus accrued interest ahead of every share class, or converts at its cap and takes the fraction if that pays more. The lab draws both beside the preferred variants for exactly this comparison.

What it means for the common

Founders and employees hold common stock, and common is paid last. That is why a company can be a reasonable outcome for its investors and a poor one for the people who built it: at a $10m sale of the worked company, a 1x non-participating preference takes half the proceeds on a 20% stake. It is also why the price of the last round is not the value of an employee’s options. Options are on common, the last round bought preferred, and the two are not worth the same thing at most exits. A 409A valuation exists to say so.

The questions to ask before joining a startup, or before recommending a round as an investor, are the same four: what multiple, participating or not, capped at what, and senior to whom. A term sheet that answers all four with "1x, no, not applicable, pari passu with earlier rounds" is a clean one.

The questions an interview asks about this

Every one of these is a rearrangement of the worked example.

• A founder has a 2x liquidation preference in the last round. What does that mean for the common? (Twice the round’s money comes out before the common sees anything, and the crossover where the investor converts is twice as far out)
• At what exit does a 1x non-participating investor holding 20% convert? (The preference divided by the fraction: $5m over 20% is $25m)
• What is the difference between participating and non-participating preferred? (Both the preference and the fraction, against one or the other; the cap decides where participation converts)
• Why does a seed investor care about the Series A term sheet? (Seniority: a senior Series A is paid in full before the seed sees anything)
• What does a SAFE get if the company is sold before it converts? (The greater of the money back and its cap fraction of the proceeds)