When do holders of preferred stock get a liquidation preference?
A liquidation preference is received upon liquidation and dissolution of the company. The issue for entrepreneurs to understand is that liquidation means both a negative outcome (in which the company is liquidated in the bankruptcy sense) and a positive outcome (in which the company is sold at a large gain in what is a liquidity event for the investors). The definition of “deemed liquidation” (or similar words) is universally drafted to include the positive event of a profitable sale of the company. Typically, the investors do not receive a liquidation preference in the event of voluntary or mandatory conversion (i.e. in an IPO). For example, in a company in which investors have invested $10 million is sold for $100 million, if the investors have a 1x participating preference, they will receive $10 million and then participate pro rata on an as converted basis with the holders of common stock in the remaining $90 million.
