Preferred Stock Liquidation Preferences

Abstract

This entry describes the use preferred stock liquidation preferences in the context of venture capital (VC) financing. Within the United States, VC investors typically invest in startups through stages, acquiring shares of the startup’s convertible preferred stock at each stage of financing. These shares include a liquidation preference that reflects the value of the startup at each stage of financing and that entitles the investor to receive preferential payments on its preferred shares on a liquidation or sale of the company prior to any distributions to the company’s common stockholders, who are often the company’s founders and employees. After detailing how liquidation preferences function, the entry address two complications posed by them. The first pertains to how a VC investor should assess the right to convert its preferred stock into shares of common stock during a startup’s acquisition, especially in light of the various liquidation preferences that might be present at the time of the transaction. The second relates to how the use of preferred stock liquidation preferences influence the valuation of a startup and its common stock.