Term Sheet 101: The Liquidation Preference


Term Sheet 101

The liquidation preference means, generally, that the investors holding Preferred Stock will receive their money back in full upon a liquidation of the corporation, including a deemed liquidation which includes a sale of the corporation, before any liquidation or sale proceeds are distributed to the holders of common stock. Normally, a liquidation preference is for one times (1X) return of capital, but in distressed situations the “up front” liquidation preference may be higher.

If the liquidation preference is non-participating, it means that it is capped at the “up front” amount, so the investors holding Preferred Stock have “down side” protection in a distressed sale of the corporation, but the “up side” of owning the preferred is limited. The Preferred Stock is convertible into common stock, however, so the investors do have unlimited up side on the investment if they convert to common, but they have to forego the liquidation preference.

Here is an example. Suppose that the investors put in $1MM for 25% of the corporation. If the corporation later sells for $2MM, the investors would want their money back through the liquidation preference and take 50% of the sale proceeds. If the corporation were sold for $8MM, however, the investors would be better off converting their preferred shares into common shares and taking 25% (their pro rata amount) of the total, and so $2MM. In this scenario with a non-participating preferred, the inflection point for converting to common stock is a sale that will yield $4MM to the stockholders of the corporation.

With participating preferred, the investors enjoy both the liquidation preference and the up side of owning the shares issuable upon conversion of the preferred. The investors in the $8MM sale scenario would receive their liquidation preference of $1MM, and then would participate with the holders of common stock on an as-converted to common stock basis on the remaining $7MM and so receive $1.75MM of the remaining proceeds (25% * $7MM), for a total return of $2.75MM. For investors, a participating preferred is the best of all worlds, less risk with more reward. Whether the preferred is participating can have a significant impact on how the pie is divided between preferred and common stockholders upon a sale of the corporation.

Another wrinkle: sometimes the participation will be capped. So, for example, the investors get their money back first, then participate with the common stockholders until they have received a total of [2X – 5X] their investment, but then participation would stop. Illustrating this example if the investors had participation up to 3X of their investment, assuming the same scenario, if the corporation were sold for $10MM, the holders of Preferred Stock would receive $1MM “off the top” and then take 25% of the remaining $9MM, or 2,250,000. Add that to the $1MM off the top, and the sum is $3.25MM. Because that number exceeds the cap, however, the liquidation preference would be limited to $3MM. At a $10MM exit for the stockholders, this liquidation preference is still better than converting to common stock and taking 25% of the total (which, at a $10MM exit, would yield $2,500,000). In fact, the inflection point for converting to common is now a $12MM exit, where a liquidation preference with a $3MM cap and 25% of the total balance out. Over $12MM, the investors would convert to common, forego their liquidation preference and take their pro rata share of the sale proceeds.

I made a tool to help explain how the liquidation preference can change the economics of how the pie is divided. It literally “bends the lines” based on whether you choose participating or non-participating preferred (or participating to a cap), and also whether there are cumulative dividends (which, if unpaid (which is almost always true for a tech company)) will increase the amount of the liquidation preference of the preferred. To play “what if” with different liquidation preference provisions, click here.

This article was originally published on Venture Docs, an online platform for automating the creation of important legal documents for startup companies, investors, crowdfunding portals and attorneys.

About the author: Bo Sartain

Bo is a practicing corporate attorney with the law firm of Haynes and Boone, LLP.  Bo’s legal practice focuses on the representation of investors and issuers in company formation, private equity and venture capital preferred stock and preferred LLC membership interest equity financings, and the representation of buyers and sellers in mergers and acquisitions. Formerly, Bo was a Systems Engineer and the founder and CEO of a startup software-as-a-service company.

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