Key Term Sheet Provisions: Liquidation Preference

It’s Friday, so it’s time to continue our series on term sheets and take another look at an important provision in a financing term sheet. Today we’re discussing liquidation preference.

Liquidation preference terms only come into effect when there is a liquidation event. A liquidation event is usually defined as a merger, acquisition, or sale of substantially all company assets.

Preference and Participation
There are two components to a liquidation preference: preference and participation. Preference terms govern the taking of assets before other stock classes, participation terms instruct how the remaining assets are to be divided after the preference is allocated.

Preference
On the occurrence of a liquidation event, investors generally want to be ensured that they will receive at least their original investment. Investors negotiate for liquidation preferences to protect their interests in such a scenario. A liquidation preference entitles holders of a class of stock to receive the assets of a liquidated company before holders of other classes of stock (usually the earlier investors and the founders) receive anything. The preference is generally calculated as a multiple of the original investment, often the term provides that the original investors receive 1x (their original investment), but in the pre-Internet bubble era, investors sometimes received a preference as high as 10x.

The “liquidation preference” term also incorporates the liquidation participation terms. But it is important to understand that preference and participation are two different things.

Participation
It is important to distinguish between the three varieties of participation:

(1) fully participating stock – shares of fully participating stock receive their preference before the subordinate classes, but then participate in the distribution of the remaining assets on an “as converted” basis. “As converted” means that for purposes of calculating the distribution of the assets, the preferred stock is treated as having converted to common stock prior to the liquidation event. (The terms of preferred stock generally provide a conversion ratio for converting preferred stock to common stock.)

(2) capped participation – shares of stock that have capped participation receive their preference before the subordinate classes, but then participate in the distribution of the remaining assets on an “as converted” basis up to a certain cap which is generally related to a multiple of their original investment. For example a class could have a 2x preference (they get double their investment before any other classes get anything), and a 4x participation cap (they participate in the distribution of the remaining assets until they have received four times their original investment). The 4x participation includes the 2x preference – that is, the investor does not get a combined 6x return.

(3) no participation – if the series of stock is not participating, shareholders of that stock will be entitled to their preference, but will not participate in the further distribution of assets.

Some Examples
Let’s take a look at a couple of examples to see the impact these terms can have. For both examples we’ll build off the numbers used in the previous blog post in this series (on valuation). We’ll assume a company valued at $11mm, $3mm of which was invested by Series A investors. We’ll assume the founders retain the common stock valued at $8mm.

When the company is sold for less than previously valued the preference and participation terms can severely impact the founders. Here, where we're assuming a $5mm acquisition of a company previously valued at $11mm, the difference is between receiving about $1.5mm and receiving nothing.

Example #1 The company hits hard times and is forced to be sold for $5mm.
Scenario 1: Series A has a 3x preference, and is not participating
Scenario 2: Series A has a 1x preference, a 1-1 conversion ratio, and is fully participating

In this example, under the first scenario the Series A investors have a 3x preference. That means they would take the first $9mm (3 times their original $3mm investment) of assets before holders of common stock (the founders) received anything. Since there’s only $5mm in assets, Series A get all $5mm, and the common stock holders get nothing. In the second scenario the Series A holders receive their original investment, $3mm and then participate in the distribution of the remaining assets on an as converted basis. They would get 27% of the remaining $2mm, giving them about another half million. And the common stockholders would receive 73% of the remaining assets, giving them about $1.5mm. So the difference between scenario 1 and scenario 2 for the common stock holders is the difference between getting nothing and getting $1.5mm.

When the company is sold for more than previously valued the preference and participation terms still have a major impact on the distribution of assets. Here, where we're assuming a $55mm acquisition of a company previously valued at $11mm, the difference is about $8mm.

Example #2 The company exceeds expectations and is acquired for $55mm.
Scenario 1: Series A has a 3x preference, and is not participating
Scenario 2: Series A has a 1x preference, a 1-1 conversion ratio, and is fully participating

In this example, under the first scenario the Series A investors have a 3x preference. That means they would take the first $9mm (3 times their original $3mm investment) of assets before holders of common stock (the founders) received anything. But that’s all that they’re entitled to. They take $9mm and the common holders would receive the other $46mm. In the second scenario the Series A holders receive their original investment, $3mm and then participate in the distribution of the remaining $52mm of assets on an as converted basis. They would get 27% of the remaining $52mm, giving them about another $14mm or $17mm altogether. And the common stockholders would receive 73% of the remaining $52mm in assets, giving them about $38mm. So the difference between scenario 1 and scenario 2 for the common stock holders is the difference between getting $46mm and getting $38mm.