What is a liquidation preference, and how could it affect an employee’s stock options?

A liquidation preference determines who gets paid first, and how much, among investors when a company is sold or liquidated. It basically establishes a pecking order among stockholders.

Liquidation preference means that sales and dissolutions can result in wildly different outcomes for the employees with stock options, depending on the established order.

Common Stock vs. Preferred Stock

Employees with stock options typically get common stock. Venture capitalists and other investors typically receive one of three types of preferred stock as follows:

• Straight Preferred Stock: Investors have the right to get all of their money back on a sale or liquidation or to convert their preferred stock to common stock. In the latter case, they would be treated the same as a common stockholder.
• Participating Preferred Stock: Known as the “double dip,”investors have the right to get their money back and share in the remaining sale/bankruptcy proceeds as a common stockholder according to their ownership.
• Capped Participation: The same as participating preferred stock, except that the benefit is capped at a certain limit beyond which the investor no stake.

  Preferred stockholders are paid first in a sale, merger or bankruptcy situation. If a company gives lots of preferred stock away, the employee’s common stock payout will be radically reduced when the company is sold.

  Liquidation Preference Impact on Stock Options

  Suppose, for example, that an investor buys 3 million shares of preferred stock at $1 per share, for a total investment of $3 million. The company is sold for $10 million, at which point it has 17 million shares of common stock and 3 million shares of preferred stock outstanding. An employee owns 1% of the company in common stock.

  • Without a liquidation preference, each stockholder would receive $0.50 per share. $10 million is equal to 20 million shares. The employee gets $100,000 (1% of $10 million).
  • If the preferred stockholder has Straight Preferred Stock, they will get their money back $3 million before any common stock is paid out. This leaves just $7 million to be divided among the 17 million common stockholders. The employee gets a smaller cut, $0.41 per share or $70,000.
  • If the company gives away multiple liquidation preferences or participation rights, the employee will be even further down the chow line come feeding time.

  Liquidation Preferences and the HR Manager

  Since liquidation preferences determine how, and how much, an employee will be paid, you or another administrator may need to explain to employees exactly how they determine value of their common stock options.

  Things to address include:

  • The total liquidation preference (how much preferred stock is issued)
  • Whether investors have participation rights
  • If the company were sold today, what would the employee’s shares be worth on the most recent company valuation?

  At the point of liquidation or sale, you would need to provide follow up information based on the company’s actual sale value.

  Helpful Links:

  • Stock Option Counsel: Startup Negotiations: How Preferred Stock Makes Employee Stock Less Valuable This attorney-written resource explains the impact of liquidation preferences on an employee’s stock options.
  • Wealthfront: The Wildly Different Financial Outcomes for Employees in Acquisitions This resource explains the outcome for employees in different types of company sale.
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