Meaning
A security provision in venture contracts determines the order and amount of payout to preferred shareholders during an exit or winding up. This liquidation preference ensures that preferred investors receive their initial capital back, often with a multiplier, before common shareholders receive any proceeds. The boundary of its impact is reached when the exit valuation is high enough that preferred shares convert to common shares, rendering the preference moot.
Payment Priority
Distributing proceeds during a sale starts with the senior debt and then proceeds to preferred shares. When liquidation preference is set at one time the investment amount, it provides a floor that protects investors in low-value exits. This protection shifts the downside risk of the venture from the investors to the founders and employees.
Dilution Risk
High preference multipliers or participating features can drain the exit pool, leaving nothing for holders of common stock. Founders who accept these terms may find that even a successful sale yields little personal return.
Structural Design
Structuring these provisions with a cap on participation limits the upside payout of preferred shares. This cap balances the protection of the investor with the incentive of the operational team to pursue high-value exits.
