Venture Capital Term Sheet: Liquidation Preference (PART 2: Preference Multiples)

Eric A Koester

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Venture Capital Attorney

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Posted over 5 years ago. 3 helpful votes

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1

Recap: 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.

2

What are Preference Multiples?

In some cases, the liquidation preference may be great than 1x - sometimes 2x or 3x. This is referred to as a preference multiple. In this case, in the event of a sale or liquidation of the company, the investor will first receive 2x or 3x its initial investment before the remaining funds are distributed.

3

Case Study: How the Preference Multiples Work

This time, Company A again raises $6 million on a $6 million pre-money valuation for a total valuation of $12 million post-money. The investors have a 3x preference multiple, meaning they would receive $18 million back in a liquidation or sale event, before any other shareholders are paid. One year later, the company receives an offer to buy the company for $20 million. The investors hold a 3x preference on non-participating Preferred Stock (see below for the difference between non-participating and participating). Now, after the liquidation, the investors will receive their $18 million (the initial $6 million investment times 3), leaving $2 million to be allocated among the common stockholders.

4

Why are preference multiples important?

The difference between using a 1x liquidation preference multiple and a 3x preference multiple equates to $8 million of additional proceeds due to the investors on this $20 million transaction ($18 million vs. $10 million if the Preferred converted into common and received 50% of the proceeds).

Additional Resources

My High Tech Startup

Starting a High-Tech Business Venture

Venture Capital Term Sheet: Liquidation Preference (PART 1: General)

Venture Capital Term Sheet: Liquidation Preference (PART 3: Participating Preferred Stock)

Venture Capital Term Sheet: Liquidation Preference (PART 4: Capped Participating Preferred Stock)

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