Liquidation preference stack

What it means

Once a company has raised more than one priced round, it has more than one class of preferred shares, each with its own liquidation preference. The stack is the order in which those preferences are satisfied on a sale. Stacked or senior seniority pays the most recent round first, then the one before it, and so on down. Pari passu, meaning on equal footing, pays every preferred holder at the same level and shares the money pro rata if there is not enough to go round. Some cap tables use tiers, grouping several rounds at one level.

Why it matters

The stack decides nothing on a strong exit and everything on a weak one. When the sale price covers all the preferences, the order is irrelevant because everybody is paid. When it does not, the order decides which investors are made whole and which take a loss, and it can leave an early backer who supported the company for five years behind a fund that arrived eighteen months ago. For founders and employees the practical significance is the total: the deeper the stack, the higher the sale price has to be before common shares are worth anything at all.

Worked example

A company has raised a EUR 2m seed and a EUR 8m Series A, both 1x non-participating, and sells for EUR 6m. Under stacked seniority the Series A is paid first and takes the whole EUR 6m, so the seed investor and the common holders receive nothing. Under pari passu the two preferences total EUR 10m against EUR 6m available, so each is paid sixty percent of what they are owed: the seed investor takes EUR 1.2m and the Series A takes EUR 4.8m. The common holders still receive nothing either way, but which investor absorbs the loss is entirely decided by a phrase in the articles. Raise a EUR 15m Series B on top and the picture changes again: the stack becomes EUR 25m, so a EUR 20m sale that would once have paid every earlier investor in full now leaves the seed round with nothing under stacked seniority.

The common mistake

Founders assuming the stack is their concern to negotiate. On a low exit the common is wiped out under every ordering, so the founders' outcome is often identical whichever is chosen, and the real argument is between the investors. Where founders should pay attention is the total size of the stack as it grows: each round adds to the amount that comes off the top, and a company that has raised EUR 30m needs to sell for more than EUR 30m before a single share of common is worth anything. The other error is reading the term sheet and stopping, since the ordering that binds is the one written into the articles of association and the two are not always the same document at the same moment.

In practice

Later investors usually ask for seniority and usually get it, on the argument that the newest money took the newest risk and is the largest cheque. Earlier investors sometimes hold pari passu if they have the leverage. Read the articles rather than the term sheet for the final position, and keep a running total of the preference stack somewhere visible, because it is the number that tells you what an acceptable offer looks like.

What to ask

Ask what the total preference stack is after this round, as one number, and write it down. Everything else about the stack is detail; that figure is the floor a sale has to clear before anybody holding common receives anything. Then ask whether this round is senior to the earlier ones or pari passu with them, and if it is senior, whether the earlier investors have agreed, because that conversation is happening whether or not you are in it. If you are an employee rather than a founder, ask the company for the total preference and the fully diluted share count, and be aware that a company unwilling to give you either has effectively told you your options cannot be valued. Ask for the articles rather than the term sheet when you want the final position, since the term sheet is a summary and the articles are the document that binds.

Related terms

• Dead zone The band of exit values across which the common shareholders receive nothing extra, however much the price rises.
• 1x non-participating preference The founder friendly liquidation preference: money back once, or the percentage, whichever is larger, never both.
• Participating preferred stock Preferred shares that take their liquidation preference and then also share in what is left over.