There are two basic types of liquidation preferences: “non-participating” and “participating.”
“Non-participating” preferred typically receives an amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event. Holders of common stock then receive the remaining assets. If holders of common stock would receive more per share than holders of preferred stock upon a sale or liquidation (typically where the company is being sold at a high valuation), then holders of preferred stock should convert their shares into common stock and give up their preference in exchange for the right to share pro rata in the total liquidation proceeds. Non-participating preferred stock is favored by holders of common stock (i.e. founders, management and employees) because the liquidation preference will become meaningless after a certain transaction value.
Please note that each series of preferred stock may be economically incentivized to convert to common stock at different transaction values due to different preference amounts per share for the different series. This necessitates creating complex spreadsheets to model what happens upon a sale of company at different transaction values. The most sophisticated spreadsheets will also take into account whether options and warrants are in the money at certain transaction values, which will affect whether or not they are exercised, which will then affect the price per share. These circular formulas are best left to CFOs with strong math skills or attorneys that deal with these spreadsheets all the time.
“Participating” preferred also typically receives an amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event. However, participating preferred then participates on an “as converted to common stock” basis with the common stock in the distribution of the remaining assets.
Participating preferred stock is favored by investors because they will receive a preferential return over both low and high exit transaction values. An argument in favor of participating preferred stock is that if a company is sold shortly after the investment, the founders may receive a significant return on their investment (since they have typically paid a much lower price than holders of preferred stock) while the holders of preferred stock may receive little or no return on their investment, particularly where the liquidation preference is 1x. A counter-argument is that if a company is sold for a high price, the holders of preferred stock have no incentive to convert their shares into common stock and, as a result, are able to “double-dip” into the proceeds by receiving both the preference amount and the participation proceeds. Thus, one compromise is a participating preferred with a cap, which will be covered in the next post.