A liquidation preference gives the preferred stock the right to get paid before the common stock. It sets forth the order of return to the investors triggered by certain events such as a liquidation, dissolution, merger, acquisition or sale of all, or substantially all, of its assets. The liquidation preference outlines who will get paid first and how much they will get paid. For example, a liquidation preference could be an amount equal to the initial purchase price or a multiple of the initial purchase price. Therefore, if Sandy Hill Ventures invests $2 million in TechStartup, Inc., the liquidation preference could provide that Sandy Hill will get their $2 million back before the holders of common stock get anything. Therefore, if the company was being liquidated for $4 million, the investor would at least get the $2 million first and then the other $2 million would be divided among the common stock.
Liquidation preferences can also either be participating or nonparticipating. Preferred stock with a participating liquidation preference will get their liquidation preference first and then have the opportunity to participate pro rata with the common stock. Not too long ago, the more common version of the liquidation preference was a nonparticipating liquidation preference only giving the preferred stock a liquidation preference over the common stock equal to the per share prices the investor paid or some multiple of that per share price. Therefore, a nonparticipating preferred stock is forced to make a decision — either take their liquidation preference OR convert their preferred stock to common stock and share in the bounty along with the common stock.