Liquidation preference is another important economic term that impacts how the proceeds are shared in a liquidity event. A liquidity event is usually defined as a sale of the company or the majority of the company’s assets. The liquidation preference is especially important in cases in which a company is sold for less than the amount of capital invested.
There are two components that make people refer to Liquidation preference:
Actual Preference
Participation
Liquidation preference pertained only to the money returned to a particular series of the stock (ie, Series A or Common Stock)
Liquidation Preference: In the event of any liquidation or winding down of the Company, the holders of the Series A Preferred shall be entitled to receive, in preference to the holders of the Common Stock, per share amount equal to [X] times the Original Purchase Price plus any declared but unpaid dividends.
Normally, the Liquidation Preference for the company will be 1x the original purchase price (ex, Investor invests $10million and the company sold for $10millio,n the Investor receives the full $10million as the Preference is 1x the original price. This Preference increases in the case of a distressed company as the investors are afraid of investing in the company.
The next thing to consider is whether the investors’ shares are participating. With participating stock, the investors will get their preference, which is usually their money back, but also receive additional proceeds after the preference is returned. While many people consider the term liquidation preference to refer to both the preference and the participation, it’s important to separate the concepts. There are three varieties of participation: no participation, full participation, and capped participation.
No Participation: It means the stock does not participate after receiving the liquidation preference. In simple terms, if the Investor invests $20Million and the company sold for $100million. The investor would receive only $20Million. In this case the Investor can convert its preferred stock to common stock and get the potential upside from the sale of the company. preference effectively provides downside protection for the investors while allowing them to have the upside in an exit where they choose to convert to common stock.
Full Participation: In this case, the stock will receive its liquidation preference (typically 1×, as we’ve seen above), and then share in the liquidation proceeds on an as-converted basis, where “as-converted. Means they will get the iquidation preference along with the upside potential on the basis of as if converted to common stock. It's like saying "Having a cake and eating it too". For example, the investor invests $5million and owns 20% of the company, and the company has been sold for $100Million, so the investor will get his Liquidation preference of $5Million. The remaining $95Million will be split 20% to the Investor and the remaining 80% to the common shareholder.
Capped Participation: Stock will receive its liquidation preference and then share in the liquidation proceeds on an as-converted basis until a certain multiple of the original purchase price is reached. One interesting thing to note in this section is the actual meaning of the multiple of the original purchase price (the [X]). If the participation multiple is three (three times the original purchase price), it would mean that the preferred would stop participating (on a per share basis) once 300% of its original purchase price was returned, including any amounts paid out on the liquidation preference, plus any declared but unpaid dividends. let’s assume that there has been only one round of financing (a Series A investment) of $5 million at a $10 million premoney valuation. The post-money is $15 million in this case. The Series A investors own 33.3% of the company (which is $5,000,000/ $15,000,000), and the entrepreneurs own 66.7% of the company.
One important term that needs to be understood is Liquidation Preference Overhang, which is the money that needs to be given to the preferred holder before any common stockholders.
Liquidation preferences are usually easy to understand and assess when dealing with a Series A term sheet. It gets much more complicated to understand what is going on as a company matures and sells additional series of equity, since understanding how liquidation preferences work between the various series is often mathematically, and structurally challenging. There are two approaches to deal with it
The follow-on investors will stack their preferences on top of each other (known as stacked preferences) where Series B gets its preference first, then Series A.
The series are equivalent in status (known as pari passu or blended preferences), so that Series A and B share pro-ratably until the preferences are returned.
It boils down to the ability of the company to negotiate and its negotiating power with multiple VCs on board to get the best deal.
Let’s look at an example. This time, our example company has raised two rounds of financing, a Series A ($5 million invested at a $10 million pre-money valuation) and a Series B ($20 million invested at a $30 million pre-money valuation). And the company is sold for $15 million. If the preference is stacked, the Series B investors will get the entire $15 million. In fact, in this case, it won’t matter what the pre-money valuation of the Series B was; they’ll get 100% of the consideration regardless. However, if the preference is blended, the Series A will get 20% of every dollar returned (in this case $3 million) and the Series B will get 80% of every dollar returned (or $12 million), based on their relative amounts of the capital invested in the company.
Lastly, it is better to keep the preference simple in the early rounds of financing, as it can impact future funding rounds and try to negotiate for non-participation shares or negotiate for kick-outs/ caps for the investor.
