What is a Liquidation Preference?

A liquidation preference is a right attached to preferred shares. When the company is sold, the holders of those shares are paid a set amount out of the proceeds before ordinary shareholders receive anything, usually the money they invested. A non-participating holder takes that amount or their percentage share of the proceeds, whichever is larger. A participating holder takes that amount and then their percentage share of what remains as well. Either way the set amount comes out first, which is how Trados sold for $60 million in 2005 and its ordinary shareholders received nothing.

A liquidation preference is a right attached to preferred shares. When the company is sold or wound up, the holders of those shares are paid a set amount out of the proceeds before ordinary shareholders receive anything. Investors ask for a preference because a young company can sell for less than they invested, and ordinary shares would only give them a percentage of a poor price. The set amount is usually the money they invested, sometimes a multiple of it, and unpaid dividends are added to it each year. Two versions of the preference exist. With a non-participating preference, the holder takes either the set amount or their percentage share of the proceeds, whichever is larger. With a participating preference, the holder takes the set amount first and then also their percentage share of whatever remains. In both versions the set amount comes out before anyone else is paid, so the smaller the sale, the larger the share of the proceeds the preference takes. One example of an extreme case is Trados, which sold for $60 million in 2005. A management bonus plan was paid first and took $7.8 million, leaving $52.2 million. By then the preference had grown to $57.9 million, more than the $52.2 million that was left, so the preferred holders took all of the $52.2 million and the ordinary holders received nothing. A preference is not a debt: nobody owes the money, and the preference applies only when the company is sold or wound up. The preference decides who is paid; drag-along rights decide whether you are made to sell at all, and in a listed company that job falls to a squeeze-out merger.

Two people open a florist. One puts in $80,000 for half the shop, and the other owns the other half and runs the shop every day. The agreement gives the investor a participating liquidation preference of $80,000, the amount put in. The shop sells for $94,000. The investor takes the $80,000 first and then half of the $14,000 that remains, $87,000 in all, and the working partner keeps $7,000. Had the preference been non-participating, the investor would have taken only the larger of the $80,000 or half the price, so $80,000, and the working partner would have kept $14,000. Same shop, same buyer, and one word in the agreement halves what the person who ran the place takes home.