Let’s start with the different kinds of stocks.
Common vs. Preferred Stock
Startup employees who receive stock usually get common stock. This means that their ownership in a company allows them certain voting rights, including the right to vote on any significant changes to corporate policy (e.g., mergers and acquisitions), and electing the board of directors. They are also among the very last to be paid in the event of a company’s insolvency. They get the leftovers of a company’s assets - if any - only after preferred shareholders, bondholders and secured debt holders have been paid in full. On the other hand, they tend to outperform preferred stock.
Startup investors typically get preferred stock. It’s the liquidation preference that pretty much defines preferred stock. Unlike common stock, preferred stock offers enhanced liquidation preferences. In other words, preferred stockholders have higher priority over common stockholders in the event of a company’s liquidation, entitling them to be paid first, ahead of others with the exception of bondholders and secured creditors (if any). In this context, liquidation means either the company is sold or declares bankruptcy.
(As a side note, if the company goes to public offering, preferred stock converts to common stock and the liquidation preference is extinguished.)
The reason why investors invariably receive liquidation preference (if they have preferred stock) over common stockholders is because they are taking larger risks by providing startups with substantial capital. In order to mitigate those risks, liquidation preference assures those with preferred stock that in the event of the company’s insolvency (whether it files for bankruptcy or is sold), they’ll get paid before everyone else, except for perhaps bondholders and secured creditors.
This becomes particularly crucial if there isn’t enough money to repay other debt holders if there’s a liquidity event. Since investors took great risk in the early stages of a startup’s life, they want to ensure that they can be made whole as much as possible. Liquidation preference is their insurance policy.
Early investors typically receive a 1x liquidation preference, which means they can recover up to the full amount of their original investment. However, it’s possible to see some early investors given as much as a 2x, 3x or even higher liquidation preference.
The way it works for a simple 1x preference is like this:
- VC invests $10 million for 50% equity in a $20 million post-money valuation transaction.
- If the company is sold for $15 million, VC gets their original $10 million first, plus half of the remaining $5 million, for a total of $12.5 million.
- The remaining $2.5 million is split between the common stockholders.
However, if the VC’s liquidated preference is greater than 1x, then they would would receive everything, leaving nothing left for the common shareholders to split.
Preferred shares are also either participating or nonparticipating preferred.
If they’re participating, then they receive their liquidation preference plus an additional portion of the proceeds after all liquidation preferences have been paid. This essentially means that once all liquidation preferences have been satisfied, their preferred stock would be treated as common stock for purposes of calculating the additional payout.
If they’re nonparticipating, then they do not participate as common shareholders after the preferred are paid; they receive only their liquidation preference.