What is a liquidation preference?
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Short answer
A liquidation preference is an investor's right to be paid back before common shareholders when the company is sold, merged or wound up. A 1x non-participating preference means the investor gets the greater of their money back or what they'd get by converting to common. Multiples and participation rights increase what investors take first, which matters most in modest exits.
What does a liquidation preference do?
It decides the order of payment. When a company with preferred shares is sold or wound up, holders of those shares are paid their preference first, and what’s left goes to common shareholders, usually founders and employees. In Canada, the preference is a right attached to the share class in the articles, under section 24 of the CBCA or section 22 of Ontario’s Business Corporations Act. Most venture terms treat a sale of the company as a “deemed liquidation”, so the preference applies to an acquisition, not just a wind-up.
What are the common types?
| Type | What the investor gets on a sale |
|---|---|
| 1x non-participating | The greater of their investment back, or their as-converted share of the proceeds |
| Multiple (for example 2x) non-participating | The greater of twice their investment, or their as-converted share |
| 1x participating | Their investment back, and then their as-converted share of what remains |
| Capped participating | Participating, until total returns reach a set multiple |
Can you show an example?
An investor put $2,000,000 into the company for 20% on an as-converted basis. The company is sold for $6,000,000.
| 1x non-participating | 1x participating | |
|---|---|---|
| Investor takes first | $2,000,000 (beats 20% of $6M = $1.2M) | $2,000,000 |
| Then shares in the rest | No | 20% of $4,000,000 = $800,000 |
| Investor total | $2,000,000 | $2,800,000 |
| Common holders total | $4,000,000 | $3,200,000 |
At a $60,000,000 sale, a non-participating investor would convert and take 20%, $12,000,000, and the preference wouldn’t matter. Preferences bite in small and middling exits.
What is the liquidation stack?
After several rounds, each series has its own preference. They can be paid in order (latest round first) or equally (pari passu). The total of all preferences is the “stack”. Common holders get nothing until it’s paid, so a large stack can leave founders and employees with little even from a sale that sounds substantial.
Do SAFE holders get a preference?
Not before conversion, in the usual way. Y Combinator’s SAFE gives the investor a right, on a sale before conversion, to the greater of their money back or the amount they’d receive on conversion, ranking ahead of common shares and on par with other SAFEs and preferred shares. After conversion, they hold preferred shares with that series’ preference. See how do SAFEs work in Canada?
What should founders negotiate?
Read the preference together with the valuation. A higher valuation with a 2x participating preference can be worth less to founders than a lower one with 1x non-participating. Ask your lawyer to run the waterfall at a few exit values using your cap table, and see what is a term sheet?
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This guide is general information about Ontario and Canadian law, not legal or financial advice for your situation. To walk through a term sheet’s preference, book a free 15-minute consult.