Other attributes
The liquidation preference is a clause in a contract that dictates the payout order in case of a corporate liquidation.
Depending on the deal terms, investors can be entitled to a multiple of their initial investment, but the majority of VC deals carry a 1x or smaller liquidation preference.
Liquidation preferences are one of several benefits potentially available to holders of preferred stock in a privately-held company.
Subject to shareholder agreements and the legal structure of a company, preferred stock may be either "participating" or "non-participating," which dictate preferred a preferred stockholder's right to dividends or proceeds from a liquidation event in relation to holders of common stock.
In short, participating preferred shareholders are entitled to receive their initial investment (or a pre-determined multiple thereof), plus a pro rata share of the remaining capital in a liquidation event.
Non-participating preferred shareholders are entitled to either their initial investment amount (or a pre-determined multiple thereof) or their pro-rata share of proceeds from a sale.
A company's capital structure codifies the order in which proceeds from a liquidation event is distributed to stakeholders in a company. Prior to distributing assets to equity holders, a company is typically required to fulfill its financial obligations to its creditors and only then start making distributions to equity holders.
Preferred shareholders are given a senior position in the company's capital structure, entitling them to proceeds of a liquidation before holders of common stock receive theirs.
In a venture capital-backed company, the highest level of seniority amongst preferred equity holders is typically given to preferred shares originated in the last round of funding prior to an acquisition.
If a Series C-stage company is acquired, holders of Series C preferred stock are the first to receive proceeds from the transaction. Once Series C preferred stockholders are fully liquidated, Series B preferred stockholders are liquidated, followed by Series A preferred and (if applicable) Series Seed preferred shareholders.
After preferred stockholders are liquidated, common stockholders (typically founders, employees, advisors, and service providers who may have received equity as part of their contracts) are entitled to their proportional share of the remaining proceeds from a liquidation. (e.g. An employee whose common stock equity is equal to 0.1% of the company on a diluted basis is entitled to 0.1% of the remaining liquidation proceeds after preferred shareholders are liquidated.)
Depending on the terms and economics of a particular liquidation transaction, it's possible for common shareholders and preferred shareholders with lower levels of seniority to receive no proceeds from a transaction.
Pari passu is a Latin phrase which translates to "with equal step." In the context of seniority in a company's capital structure, it means that all involved parties within a specific group of stakeholders are treated equally and without preference. Historically, a majority of U.S. tech companies have a pari passu liquidation preference.
Preferred stock is still typically given seniority over common stock, entitling preferred shareholders the right to receive proceeds prior to common shareholders. However, under pari passu, preferred shareholders are not given seniority over one another.
If a Series C-funded company receives and accepts an acquisition offer, Series A and Series B preferred shareholders receive their liquidation proceeds alongside Series C preferred shareholders.
Companies with more complex capital structures may have a mix of senior and pari passu liquidation preferences for different types of preferred shareholders.
For example, a company which raised venture capital funding and later raised private equity funding may have a senior liquidation preference amongst its private equity investors, but may treat the holders of preferred shares from its prior venture capital rounds as a collective bloc under pari passu.
