The liquidation preference is perhaps one of the most important clauses found in a VC term sheet.
A liquidation preference represents the amount the company must pay at exit (after secured debt, trade creditors, and other company obligations) to the preferred investors. In effect, liquidation preferences protect the downside risk to preferred investors.
The liquidation preference gives the investor the option, in a liquidity event, of either receiving their liquidation preference as their return or converting into common shares and receiving their percentage ownership as their return.
The two most common types of liquidation preferences in Venture Capital (VC) are:
1) Non-Participating Preference
- Commonly referred to as “straight preferred”
- Liquidation preference = Investment * Liquidation Pref. Multiple
- Will involve a multiple such as 1.0x or 2.0x
2) Participating Liquidation Preference
- Commonly referred to as “participating preferred”, “full participating preferred”, or “participating preferred with no cap”
- In this structure, investors first receive their liquidation preference and then share in the remaining proceeds on a pro-rata basis (i.e. “double-dipping”)
- Capped Participation:
- Commonly referred to as “capped participating preferred”
- Capped participation indicates that the investor will share in the liquidation proceeds on a pro-rata basis until total proceeds reach a certain multiple of the original investment
Liquidation Preference Example
Let’s look at an example to highlight how liquidation preferences work:
There are four potential outcomes for an investor investing $1 million for 25% of a company that later sells for $2 million:
Outcome #1: No Liquidation Preference
Without a liquidation preference, investors get only $500,000 (25% of proceeds), losing half of their capital, while the common shareholders receive $1.5M.
Outcome #2: Non-Participating at 1.0x Liquidation Pref.
Investors would get $1 million from their 1.0x preference, with common getting the remaining $1 million.
Outcome #3: Participating 1.0x Liquidation Pref.
Preferred investors get $1 million off the top plus another $250,000 (25% of the remaining $1 million). The common shareholders would receive $750,000.
Outcome #4: Participating 1.0x Liquidation Pref. with 2x Cap
Preferred investors get $1 million off the top plus another $250,000 (cap does not go into effect).
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