What is a Liquidation Preference?
The vast majority of term sheets will include a liquidation preference for the Preferred Stock - basically ensuring that the investors are paid out first if the company dissolves or is liquidated through a merger or acquisition. Nearly all venture financings have a liquidation preference, but there will often be negotiation around the details of how the preference works.
When does a liquidation preference come into play for my company?
A liquidation preference comes into play in one of two situations: (i) the company fails and has to sell the remaining assets and liquidate the business, or (ii) the company is acquired by or sold to another company (or also a merger transaction where the current shareholders wind up no longer owning the company). In each of these cases, the shares will end up liquidated and need to determine how to divide the proceeds from the transactions. The liquidation preference for the investors ensures that the investors are the shareholders that will be paid back first, allowing the investor to recoup their initial investment (and perhaps more). Then, after the preference is paid, any proceeds that remain will be allocated proportionally to the common stockholders.
Case Study: How the Liquidation Preference Works
Company A raises $6 million on a $6 million pre-money valuation for a post-money valuation of $12 million. Now the founders of Company A own 50% of the company and the investors own the other 50% in preferred stock. One year after the financing, an offer is made by a third-party to buy the company for $10 million. In this simple example (and absent any liquidation preference), the founders would get $5 million of the proceeds (50% of $10 million) and the investors would get the other $5 million. Do you see the problem here? On this transaction, the investor just lost $1 million, while the founders just made $5 million. That's not a great business model, is it? So to prevent this from occurring, the investor will require a liquidation preference. This insures that the Series A investors get paid back first - their full $6 million investment - before anyone else gets paid.
Why is the liquidation preference so important?
The example above is the reason the liquidation preference is typically the most important economic right of the Preferred Stock (and the major reason why it is usually valued 10:1 over common stock, as discussed earlier). Having this liquidation preference insures that even if things sour, the investors are going to be paid back first. Generally, the liquidation preference is written in such a way that preferred shareholders receive their purchase price prior to any payment to common shareholders in the event of a liquidation or dissolution of the company, and usually, also in the context of a merger or other acquisition of the company.
What should you expect for liquidation preferences?
Percentage of Series A deals that have liquidation preferences: 97% Series A 97% Series B 98% Series C 100% Series D 99% Source: Private Company Financing Report, Cooley Godward Kronish LLP, August 2007