Liquidation Preferences: Standard & Non-Standard Terms
Liquidation preferences
Author: Kristoffer Warren
Read time: 9 minutes
Published date: 7 August 2023
We cover both standard and non-standard terms for each of the various rights and liquidation preferences, and how they can affect stockholder payouts.
Contents
- Liquidation preferences
- What are liquidation preferences?
- How do liquidation rights and preferences work?
- Original issue price
- Liquidation preference
- Liquidation multiplier
- Cumulative dividends
- Conversion ratio
- Participating preferred
- What is a term sheet?
- How to model a future exit scenario
- Scenario modeling with Carta
What are liquidation preferences?
When a private company has a liquidity event like getting acquired in an M&A transaction or winding down, shareholders are typically paid out for their equity holdings, such as common and preferred stock.
Among other things, liquidation rights and preferences guarantee that preferred shareholders are paid first after an exit event, thereby optimizing for receiving a minimum return on their invested capital.
How do liquidation rights and preferences work?
Rights and preferences are typically classified as “standard” or “non-standard.”
- Standard terms are more common and are friendlier to common stockholders when a company exits.
- Non-standard terms are less common and are usually more onerous in their treatment of common stockholders when a company exits. Non-standard terms enhance the downside protection, or sometimes even the upside potential, that an investor receives upon a liquidation event.
Your particular company’s rights and preferences may include a mixture of standard and non-standard terms. Who gets paid what (and when) is primarily dictated by the following rights and preferences:
- Original issue price
- Liquidation preference
- Liquidation multiplier
- Cumulative dividends
- Conversion ratio
- Participation
Original issue price
The original issue price (OIP) is the price at which investors purchased preferred shares. The OIP also dictates the investor’s liquidation preference. Under standard terms, the liquidation preference equals the preferred shares’ OIP multiplied by the investor’s outstanding number of preferred shares.
Liquidation Preference = OIP x # of Outstanding Preferred Shares
Liquidation preference
As mentioned earlier, a preferred shareholder’s liquidation preference is typically paid out first as a result of seniority rights. Seniority levels assigned to share classes will determine which share classes get paid out first.
| Investors | Standard | Non-standard |
| Series B | Liquidation preferences are paid together on a pro-rata basis | Paid out first |
| Series A | Liquidation preferences are paid together on a pro-rata basis | Paid out second |
| Series Seed | Liquidation preferences are paid together on a pro-rata basis | Paid out last |
Liquidation multiplier
An example of a non-standard term is when preferred shareholders have a “liquidation multiplier.” These terms allow investors to receive a “multiple” of their liquidation preference before choosing to convert their preferred shares into common shares.
| 1x multiplier | Ownership | Results if company sells for $1M | Results if company sells for $2M |
| Preferred shareholders | 1M shares of preferred stock with 1x multiplier | Receive $1M | Receive $1M |
| Common shareholders | 1M shares of common stock | Receive nothing | Receive the other $1M |
| 2x multiplier | Ownership | Results if company sells for $1M | Results if company sells for $2M |
| Preferred shareholders | 1M shares of preferred stock with 2x multiplier | Receive $1M | Receive $2M |
| Common shareholders | 1M shares of common stock | Receive nothing | Receive nothing |
Cumulative dividends
Cumulative dividends are non-standard terms associated with preferred stock. Because startup dividends are typically not paid out regularly, you can think of cumulative dividends as similar to interest that accrues on debt. For preferred shares, dividends are designated as either cumulative or non-cumulative.
- Cumulative dividends are earned and accrued over time, whether or not it is declared by the board. However, cumulative dividends are typically only payable if and when declared by the board.
- Non-cumulative dividends are declared and paid out only at the discretion of the board.
Conversion ratio
As stated previously, preferred shareholders will elect to convert their preferred shares into common shares if it would result in a payout greater than the preferred shares’ total liquidation preference.
| Investor | $0.80 value of common share upon exit (if converted) | $1.20 value of common share upon exit (if converted) |
| OIP of $1 and 1M preferred shares | The investor would rather maintain their liquidation preference and receive a payout of $1M | The investor would rather convert their preferred shares into common shares and receive a payout of $1.2M |
Participating preferred
Participating preferred stock gives preferred shareholders an economic benefit that allows them to receive additional proceeds—on top of their liquidation preference—before converting their preferred shares into common shares and participating in the remaining proceeds alongside common shareholders.
What is a term sheet?
A term sheet lays out the basic terms and conditions on which the investor(s) are offering to infuse capital, in exchange for equity in the company.
How to model a future exit scenario
Our free exit simulator tool helps you simulate the effects of common term sheet provisions so you can assess your liquidation rights and preferences based on fundraising, equity, and dilution.
Scenario modeling with Carta
Even if an exit event isn’t in your company’s immediate future, you can use Carta’s other scenario modeling tools to automatically calculate the payout to equity holders assuming standard and non-standard terms. Scenario modeling (which is included in Carta’s Growth and Scale plans) is an easy way for companies to ensure they’re in the driver’s seat when the time comes to negotiate terms during a fundraising round.