The Liquidation Preference:
Liquidation Examples, Preferred Stocks and How it Works for Startup Investing
As a venture capital investor, angel investor, or someone about to invest in startups, one of the most important terms that you need to familiarize yourself with is called the liquidation preference. In essence, this is a term that describes exactly how investors are going to get their initial investment back if a liquidity event should take place. A liquidity event is defined as something like a merger, a purchase or a sale. An initial public offering (IPO) would also fall under this definition. There are a few important things about the liquidation preference that both startups and investors need to know.
How Is the Liquidation Preference Calculation Performed?
There are three major ways that are commonly used to define a liquidation preference preferred stock scenario. The first is a non-participating preference, which is also often referred to as a straight preference. Under this scenario, the original investors will get back the entirety of their initial investment plus unpaid dividends that may have accrued over the lifetime of the relationship. Depending on the nature of the liquidation event, an investor may get back two, three or even four times their original investment.
If an investor originally put $1,000,000 into a company and had a 2X multiple liquidation preference, they would then receive $2,000,000 as a part of the liquidation event, plus any dividends that were agreed on originally.
The next major type of liquidation preference is called the participating preference without a cap. The original investors will be paid back their investment in the form of preferred stock, which enables investors to receive shares in the proceeds from the sale of the company. Depending on the liquidation preference, the original investors may also have a multiple payment option as a part of this agreement.
If an investor puts $1,000,000 into a company, has a 2X multiple and is also entitled to $5,000,000 as part of the balance of the sale of the company, they would get a total of $7,000,000.
The final major type of liquidation preference example is called a participating preference with a cap. This operates the same way that a participating preference without a cap does, except for the fact that there is a limit to the total amount of money that they can make per share. This limit usually refers in some way to a multiple of what the original investment was on a per share basis.
If an investor puts $1,000,000 into a company and has a 4x participating preference with a cap, they would be entitled to recoup their original investment but would essentially stop being paid once their return on investment equals $5,000,000.
Further Liquidation Preference Examples
Sometimes the liquidation preference calculation isn't just as simple as looking at the original investment of VCs regarding the sale of a company. Remember that a liquidation preference trumps common stock holders in just about every scenario. Depending on the multiplier in the liquidation preference, this could mean that even if a company sells for double what investors originally put in, common shareholders may still get nothing depending on the multiplier.
Say that investors put $5,000,000 into a company, which is roughly 25% of what it's worth. Flash forward a few years into the future and pretend that the same company sells for $20,000,000. If the original investors have a 4X multiplier as part of their liquidation preference, they would get essentially $20,000,000. In order for the common stock holders to get any type of appreciable money, the company would have to sell for many times what it is worth. This is just one of the reasons why paying attention to the terms of a liquidation preference is so important.
While situations like these may be rare, they are worth considering. The experts at Docracy agree that no participation liquidation preferences are usually the best option for the entrepreneur, but capped participation is also a great way to prevent the original investors from walking away with too much money after a sale has been completed.
As a leading, top-ranked venture capital & private equity firm, Angel Kings invests in top startups within industries such as biotech and cybersecurity. Learn how to invest in startups today, get in touch with VC expert investor, Ross D. Blankenship.
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