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.
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.
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.
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).