After three years, the liquidation preference would be 224% of the original purchase price (2x the purchase price plus three 8% returns). For example, a VC term sheet could provide for a 2x liquidation preference plus an 8% cumulative non-compounding preferred return. They can also be combined with preferred dividends. However, liquidation preferences can be equal to multiples of the purchase price, resulting in 2x, 3x, or higher liquidation preferences. This is known as a 1x liquidation preference. For instance, if a VC buys the preferred stock for $1 per share, then the liquidation preference will be equal to $1 per share. The amount of a liquidation preference can vary, but is usually linked to the purchase price of the stock itself. The liquidation preference does not come into play if the company goes public, as the preferred stock issued to investors converts to common stock and the liquidation preference goes away. Shareholders with a liquidation preference receive the proceeds of liquidation or deemed liquidation before the common shareholders, and may, depending on the exact terms of the liquidation preference, receive a percentage of the proceeds that is greater than their percentage ownership of the company (resulting in other shareholders receiving a percentage of the proceeds that is less than their percentage ownership). The liquidation preference provisions govern how the proceeds will be distributed to shareholders when and if the company is actually liquidated or is sold in an M&A transaction (called a “deemed liquidation”). The liquidation preference is essentially what makes preferred stock “preferred.” It is the most important economic provision in a venture capital financing transaction other than the valuation. This post will focus on liquidation preferences. In the prior three posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, and discussed dividends on preferred stock. Liquidation preference series#This post is the fourth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
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