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How to Calculate Liquidation Preference in a Startup Business Venture Capital Financing Term Sheet

What is the liquidation preference?

Liquidation preference refers to the rights of preferred stockholders to receive a certain amount for the preferred stock they hold in preference to common stockholders in the event of the company’s liquidation.

The extent of the liquidation preference varies between different term sheets. Some may be extremely investor-friendly, others less so. However, the purpose of liquidation preference is such that in the event of the liquidation of a company, the preferred stockholders will always receive something back for their preferred stock before the common stockholders get anything. In other words, they will always get more than ordinary shareholders. Ordinary shareholders may not get anything if the company does not even have enough assets to pay the amount of the preference.

Example A:

venture tech ltd. has 5,000,000 common shares outstanding.

In a Series A financing, Investor A invests $2,000,000 in exchange for 2,500,000 Series A Preferred Shares (ie purchase price per share = $0.8).

The condition sheet for this Series A cycle provides that:

In the event of liquidation, Preferred Shareholders will be entitled to receive, in preference to Common Shareholders, an amount equal to 2 times the purchase price per Share plus declared and unpaid dividends (the “Initial Payment”). Once the initial payment has been made in full, all remaining assets will be distributed to preferred shareholders (on an as-converted basis) and common shareholders on a pro rata basis.

NOW Venture Tech Ltd. is in liquidation and the sale price is 6 million US dollars.

Assuming no declared and unpaid dividends, and all other senior debts, e.g., employee salaries, secured debts, etc., have all been settled:

How much will preferred shareholders get?

They first receive US$0.8 x 2 = US$1.6 for each preferred stock they own.

Therefore, the upfront payment is $1.6 x $2.5 million = $4 million.

This gives US$2 million ($6-4 million) remaining, which will be distributed to preferred shareholders and common shareholders on a pro rata basis.

Therefore, Preferred Shareholders will receive an additional US$2 million x 2.5 / 7.5 = US$666,666.

That is a total of 4,666.666 US dollars.

Common stockholders will receive a total of US$2 million x 4/7.5 = US$1,333,333.

Total = $4,666,666 + $1,333,333 = $6 million

Example B:

Following Example A above, let’s say this time the sale price is US$10 million.

They will receive a total of $4 million (the initial payment) + $6 million x 2.5 / 7.5 = $6 million

Common shareholders will receive a total of $4 million.

Example C (preferred company):

Let’s give it a twist. This time, everything is as above, except that the total amount Preferred Shareholders will receive for each Preferred Share they own is capped at 4 times the purchase price per share.

In other words, they first get 2 times the purchase price per share in preference to ordinary shareholders (i.e. the initial payment as in examples A and B). Any remaining assets will then be divided between them and the common stockholders until the preferred stockholders have received 4 times the purchase price per share (plus the unpaid but reported payment and the initial payment). Any remaining assets thereafter will be distributed among all common shareholders on a pro rata basis.

NOW let’s do the math:

Aside from the sale price, since the maximum total amount preferred stockholders can get is capped at 4 times the purchase price per price, they will in no case get more than 4 x $2 million = $8 million of dollars (whatever the selling price be).

What is the break-even selling price?

Let y be the sales break-even point:

(y – 4) (2.5 / 7.5) = 8 – 4

y = 16

Therefore, the break-even selling price is US$16 million.

Therefore, the sale price must be at least US$16 million for preferred shareholders to obtain US$8 million. If the sale price exceeds $16 million, they will still only get $8 million, because the maximum amount they can get is capped.

Therefore, by setting a cap on the amount of liquidation preferred shareholders can obtain, the company is favored.

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