Liquidation Preference

A liquidation preference sets the order and amount of payment when a company's value is distributed to its shareholders. Preferred shareholders with a preference are paid a fixed amount per share, usually a multiple of what they paid (the original issue price), before the common shareholders receive anything. Founders, employees who exercise options and some early angels hold common shares, so they are paid from what is left.

Venture investors ask for it because they pay a much higher price per share than the founders did and want protection on a modest exit. It is downside protection, not a guaranteed return. It ranks behind every creditor, and on a large exit the investor usually does better by converting to common shares.

Two kinds of events trigger it. The first is an actual liquidation, dissolution or winding-up. The second, more important in practice, is a deemed liquidation event. In the CVCA model articles, which many Canadian venture capital term sheets follow, that includes an amalgamation in which the company's shareholders end up with less than a majority of the resulting corporation, and a sale, lease, exclusive licence or other disposition of all or substantially all of the company's assets. An agreed percentage of the preferred holders can waive that treatment for a particular deal.

The CVCA model term sheet offers three alternatives:

• Non-participating. Each preferred share receives the greater of its preference, for example 1x the original issue price plus declared but unpaid dividends, or what it would receive if converted into common shares. The holder takes one or the other, never both.
• Fully participating. Each preferred share receives its preference and then shares in the remaining proceeds with the common shares on an as-converted basis. It is often called double dipping.
• Capped participation. As with participating, but the total per share stops at a negotiated multiple of the original issue price. Above the cap, the holder takes the as-converted amount if that is larger.

If the proceeds cannot pay every preference in full, the CVCA articles have the preferred holders share rateably in proportion to the full amounts owed to them, and the common shares receive nothing. Where part of the price in an amalgamation depends on an earn-out or another contingency, the model articles run each later payment through the same waterfall, taking earlier payments into account. For money placed in escrow or a holdback, the parties choose between that treatment and sharing the escrow pro rata at closing.

In an Ontario corporation the preference is a share condition, not just a contract term. Section 22 of the Business Corporations Act (OBCA) requires the articles to set out the rights, privileges, restrictions and conditions of each class where there is more than one. The common shares keep the right to the remaining property on dissolution, subject to the preferred priority. A startup closing a priced round therefore files articles of amendment creating the new class and its preference.

Three points shape the drafting in Ontario:

• Classes, not series. Section 25 lets a class be issued in series, but no series may have priority for dividends or return of capital over another series of the same class. The federal CBCA has the same rule. A later round whose preference must rank ahead is therefore created as a new class, such as Class B Preferred.
• A class vote to cut it. Under section 170, an amendment that reduces or removes a liquidation preference needs a special resolution of that class voting separately, even if its shares are otherwise non-voting, and its holders can dissent under section 185.
• Share sales. In a share purchase, the buyer pays the shareholders directly and the corporation distributes nothing, so the articles' waterfall does not automatically reach the price. The CVCA model fills the gap with the drag-along in its voting agreement, which requires the consideration to be allocated as if it were liquidation proceeds under the articles. A shareholder agreement without that clause leaves the preference exposed.

Once a company has raised more than one priced round, the articles must rank the preferences:

• Stacked (senior). The newest class is paid first, then the one before it, and so on.
• Pari passu. All preferred classes share rateably in proportion to their preference amounts.
• Tiered. Groups of classes rank against each other, with the classes inside each group equal.

SAFE holders also receive preferred shares when they convert in a priced round. Under the Y Combinator Canadian SAFE, the converted shares carry the same rights as the new investors' shares except that price-based terms, such as the per-share liquidation amount, are based on the Safe Price set by the SAFE's valuation cap. A 1x preference on a converted SAFE therefore equals what the SAFE investor paid, not the round price. Our guide to priced equity rounds vs. SAFEs explains the conversion.

The total of all preferences is the preference stack. Model it on the cap table before each round. When the stack approaches the likely sale price, common shares and employee options may receive little or nothing, which hurts retention just when the buyer needs the team.

Anti-dilution protection is a separate term that interacts with the preference. It adjusts the conversion price, not the preference amount. In the CVCA model, if the company later issues shares below the current conversion price, the conversion price falls under a broad-based weighted average formula:

CP2 = CP1 × (A + B) ÷ (A + C)

CP1 and CP2 are the conversion prices before and after the new issue. A is the shares outstanding before it on a fully diluted basis, B is the new money divided by CP1, and C is the number of new shares issued. Grants under a board-approved option plan and conversions of existing securities are excluded. A full ratchet, which resets the conversion price to the new lower price however few shares are sold, is far harsher on founders.

After a down round, each preferred share converts into more common shares. A 1x preference stays fixed at the original issue price, but the as-converted alternative and any participation grow.

Other terms to model before signing:

• The multiple. The model leaves it blank; anything above 1x shifts more of a modest exit to investors.
• Dividends. If cumulative dividends accrue, the model can add accrued but unpaid amounts to the preference.
• The deemed liquidation definition. What counts as a sale, and who can waive it.
• Escrow treatment. Whether escrowed or held-back amounts count as paid at closing or only when released.

Lamba Law's cap table and stock option practice models these terms at several exit values before a term sheet is signed.

Hana Zhang and Andrés Herrera founded an Oakville medical device company. In 2024 a fund invested $4 million for Class A Preferred shares representing 25% of the company on a fully diluted basis, a $16 million post-money valuation, with a 1x non-participating preference. In 2026 a strategic buyer offers $12 million for all of the shares.

As converted, the fund's 25% would be worth $3 million, less than its $4 million preference, so it takes the preference. The drag-along in the shareholders' agreement requires the price to be allocated as if it were liquidation proceeds under the articles:

At a $40 million price the fund would convert instead and take 25%, or $10 million, leaving $30 million for common holders. A participating preference would have paid it $4 million plus 25% of $36 million, or $13 million. The breakpoint is the $16 million post-money valuation: below it the preference controls, above it conversion does.

The founders refused participation in 2024. In this $12 million sale that decision moves $2 million, before tax, to the common holders, including the employees whose options the buyer wants to keep.