What is liquidation preference?
Liquidation preference refers to preferred shareholders’ rights to receive a certain amount for the preferred shares they hold in preference to common shareholders in the event that the company goes into liquidation.
The scope of liquidation preference varies between different term sheets. Some may be extremely favorable to investors, some may be less. However, the purpose of liquidation preference is such that in the event a company goes into liquidation, preferred shareholders will always get something back for their preferred shares before common shareholders get anything. In other words, they will always get more than common shareholders. It is possible that common shareholders will get nothing if the company does not even have enough assets to settle the preference amount.
Example A:
Venture Tech Ltd. has 5,000,000 common shares outstanding.
In a Series A financing, Investors A invests $2,000,000 in return for 2,500,000 Series A Preferred Shares (i.e., purchase price per share = $0.8).
The term sheet of this Series A round provides that:
In the event of a liquidation event, the 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”). After the Initial Payment has been made in full, any assets remaining shall be distributed to the preferred shareholders (on an as-converted basis) and common shareholders on a pro rata basis.
NOW, Venture Tech Ltd. goes into liquidation and the sale price is US$6 million.
Assuming no declared and unpaid dividends, and all other senior debts, e.g., employees’ wages, secured debts, etc., have all been settled:
How much will the preferred shareholders get?
They first get US$0.8 x 2 = US$1.6 for every preferred shares they hold.
Therefore, the Initial Payment is US$1.6 x 2.5 million = US$4 million.
This gives US$2 million ($6 – $4 million) remaining, which shall be distributed to the preferred shareholders and common shareholders on a pro rata basis.
Therefore, preferred shareholders will get a further US$2 million x 2.5 / 7.5 = US$666,666.
I.e., a total of US$4,666.666.
The common shareholders will get a total of US$2 million x 4 / 7.5 = US$1.333,333.
Total = US$4,666,666 + US$1,333,333 = US$6 million
Example B:
Following example A above, let’s say this time the sale price is US$10 million.
They will get a total of $4 million (the Initial Payment) + $6 million x 2.5 / 7.5 = $6 million
The common shareholders will get a total of $4 million.
Example C (company favored):
Let’s give it a twist. This time everything is the same as above except that the total amount the preferred shareholders will get for each preferred share they hold 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 common shareholders (i.e., the Initial Payment as in Example A and B). All remaining assets will then be distributed among them and common shareholders until the preferred shareholders have received 4 times the purchase price per share (plus unpaid but declared payment, and the Initial Payment). All remaining assets thereafter will be distributed among all common shareholders on a pro rata basis.
NOW, let’s do the math:
Putting aside the sale price, since the maximum total amount the preferred shareholders can get is capped at 4 times the purchase price per price, they in any event will get no more than 4 x $2 million = $8 million (however high the sale price may be).
What is the break even point for the sale price?
Let y be the break even sale price:
(y – 4) (2.5 / 7.5) = 8 – 4
y = 16
Therefore, the break even sale price is US$16 million.
Therefore, the sale price must be at least US$16 million for the preferred shareholders to get US$8 million. If the sale price exceeds US$16 million, they will still get only US8 million, since the maximum amount they can get is capped.
That’s why by setting a cap on the liquidation amount the preferred shareholders can get is company-favored.