Liquidation preferences are a key term in the definition of preferred stock (it’s generally acknowledged to be the second most important economic term). Earlier, I wrote about this and other terms in a post on negotiating a term sheet, but here I want to give some specific examples to illustrate why this is such an important term.
You probably already know this, but it’s worth repeating that liquidation preference refers to the procedure for paying investors off in a sale or winding up of the company. It typically includes two components: a preference (which is an amount that gets paid before others) and participation (the ability to “double dip”). Many folks have written on preferences in terms of definitions, so instead I’m going to give some simple examples.
For simplicity sake, imagine a VC has $10MM invested in one class of preferred stock in a company, owns 40% and the company is sold for $50MM. Here’s how the three different scenarios in my previous post work (in a specific example):
(1) 1x preference w/ no participation. In this case, the VC has the choice to take $10MM (their 1x preference) or to convert to common and take $20MM (40% of the $50MM). Obviously, they’d want to do the latter. You might ask, what’s the value of the preference? Well, imagine if the company were sold for $15MM — in that case the VC would take the $10MM preference which would mean they really own 67% of the economics (not the 40% shown on the cap table).
(2) 1x preference capped at 2x with participation. In that case, the VC would get $10MM off the top (1x preference) and then get 40% of the rest (or $16MM) but here the cap kicks in so instead of getting the extra $16MM, the VC would get only an additional $10MM for a total of $20MM (or 2x). It’s helpful to look at a table of outcomes here:
The first column is the sale price, the second is the the value to the VC “as preferred” and the right column is the value to the VC if they convert to common (which they always have an option to do). You’ll see how the cap creates a “donut hole” where the VC receives the same amount whether the company is sold for $35MM or $50MM (because the VC would convert to common in any sale over $50MM).
(3) 1x preference with participation and no cap. In this case, the VC gets $10MM off the top, then they convert to common and get 40% of the rest (or $16MM) for a total of $26MM. In this case, the VC gets 52% as opposed to the 40% shown on the cap table. You can see with this simple example how the liquidation preference can add substantial returns for investors (which all comes out of the pocket of common).
So my view is that, no participation is the best option for common, followed by a cap and the worst deal is the no cap participation scenario.
Lastly, I would like to give a caveat on the cap scenario which is that the donut hole sometimes creates an unwelcome incentive. Imagine in the above example if there were two deals on the table: one for $35MM in cash and another for $35MM in cash plus a $15MM earn out. Further, imagine that the $35MM all cash deal is slightly more likely to close. In that scenario, the VC would be inclined to take the lower priced deal (remember they get paid the same in both scenario) but common would probably go for the higher deal.
Hacker Noon is how hackers start their afternoons. We’re a part of the @AMIfamily. We are now accepting submissions and happy to discuss advertising &sponsorship opportunities.
To learn more, read our about page, like/message us on Facebook, or simply, tweet/DM @HackerNoon.
If you enjoyed this story, we recommend reading our latest tech stories and trending tech stories. Until next time, don’t take the realities of the world for granted!
Create your free account to unlock your custom reading experience.