Liquidation Preference

We will cover Preferred Shares at length during our Live Webinar on that topic, show you how they impact dilution and exit outcomes. (We also cover them more briefly in our Live Streams).

Liquidation preference is the mechanism enabling Investors to get paid first in the case of a liquidity event (mostly a merger, sale, or dissolution).

The type of preferred shares used will decide two features:

• How much Investors get first;
• If there are any exit proceeds left, how they are divided with Common Stockholders.

Let’s take an example

We’ll start with the same assumptions we used in the Difference in Cost Base lesson:

• VCs take 20% of a Company’s equity for a $2 million investment (post-money valuation of $10 million)
• The Company is sold for $5 million five years later

Option 1: VCs own “1X” Non-Participating Preferred Shares

The preferred amount is $2 million. 

The exit proceeds are divided as follows:

	Proceeds ($M)	% of Total Proceeds
VCs	2	40%
Founders	3	60%
TOTAL	5	100%

It now becomes clear how liquidation preference protects VCs against the Difference in Cost Base. In our earlier example, VCs lost $1 million.  Thanks to the liquidation preference, they recoup their initial investment.

Note that Founders had originally sold 20% of their company, but get only 60% of the proceeds at exit vs. 80% of the shares and voting rights. 

It is the reason why we often say that preferred shares nullify entry valuations up to a certain exit amount.

Option 2: VCs own “1X” Participating Preferred Shares

This time, VCs not only take the preferred amount first ($2 million) but also their pro rata share (20%) of what is left.

The exit proceeds are divided as follows:

	Proceeds ($M)	% of Total Proceeds
VCs	2.6	52%
Founders	2.4	48%
TOTAL	5.0	100%

This is considerably worse for Founders vs. the 1X non-participating scenario.

Option 3: VCs own “1X + 15% IRR” Non-Participating Preferred Shares

In this scenario, the preference amount has a minimum return attached to it. This type of liquidation preference is mostly used in pre-IPO rounds. (Note that the minimum return is called a ‘cumulative dividend’, which is distinct from the accounting notion of dividends paid out of profits.)

After five years, the preferred amount ballooned to $4 million.

Formula: 2 * (1 + 15%) ^5 = 4

The exit proceeds are now divided as follows:

	Proceeds ($M)	% of Total Proceeds
VCs	4	80%
Founders	1	20%
TOTAL	5	100%

This is clearly the worst scenario for Founders as they now capture only 20% of the exit proceeds due to the liquidation preference parameters.

The Liquidation Preference clause in the NVCA template lists three alternatives, signaling the negotiation room for manoeuver. As you can see:

• Option 3 above is captured with the “[ _ times]” language both in participating and non-participating prefs. In pre-IPO rounds, it makes more sense to quality the minimum return as a multiple of the original investment (typically 2x or 3x) as the IPO is planned in the short term;
• Alternative 3 caps the preferred amount in the case of a participating preferred. 

Here’s how this clause is drafted in the NVCA term sheet template.

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In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

[Alternative 1 (non-participating Preferred Stock):  First pay [__ times] the Original Purchase Price [plus [accrued and] declared and unpaid dividends] on each share of Series A Preferred (or, if greater, the amount that the Series A Preferred would receive on an as-converted basis).  The balance of any proceeds shall be distributed pro rata to holders of Common Stock.]

[Alternative 2 (full participating Preferred Stock):  First pay [___ times] the Original Purchase Price [plus accrued and declared and unpaid dividends] on each share of Series A Preferred.  Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.]

[Alternative 3 (cap on Preferred Stock participation rights):  First pay [___ times] the Original Purchase Price [plus accrued and declared and unpaid dividends] on each share of Series A Preferred.  Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).]

A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) or a sale, lease, transfer, exclusive license or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above unless the holders of [___]% of the Series A Preferred elect otherwise (the “Requisite Holders”).  [The Investors’ entitlement to their liquidation preference shall not be abrogated or diminished in the event part of the consideration is subject to escrow or indemnity holdback in connection with a Deemed Liquidation Event.]

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Again, don’t worry if it’s not all clear for you yet; we will practice during our dedicated session on Preferred Shares.

Let’s end this lesson with a food-for-thought quote from Brad Feld.

Read the articles linked below. What happens when a new layer of “liquid pref” is added at each new round of funding? Why is VC called a “Go Big or Go Home” game?

Let us know in the Comments section below.

🔎 Sources and Additional Material

• The Risk of a Billion-Dollar Valuation in Silicon Valley, by Steven Davidoff Solomon aka the “Deal Professor” (2015)
• Term Sheet: Liquidation Preference, by Brad Feld (2005)
• Liquidation Preference: Your Equity Could Be Worth Millions – Or Nothing, on AngelList’s blog (2018)