How to calculate the liquidation preference in a venture capital funding term sheet for a startup company

What is Liquidation Preference?

Liquidation preference refers to the right of the preferred shareholders to receive a specified amount for the preferred shares they hold over the common shareholders in the event of a liquidation of the company.

The scope of the liquidation preference varies between the different term sheets. Some may be extremely favorable to investors, others may be less so. However, the purpose of liquidation preference is that if a company goes into liquidation, preferred stockholders always get something back for their preferred stock before common stockholders get anything. In other words, they will always get more than ordinary shareholders. It’s possible that common shareholders will get nothing if the company doesn’t even have enough assets to pay the preferred amount.

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 term sheet for this round of Series A provides the following:

In the event of a liquidation, the Preferred Stockholders will be entitled to receive in lieu of the Common Stockholders an amount equal to twice the purchase price per share plus any declared and unpaid dividends (the “Initial Payment”). After full deposit, the remaining assets will be divided pro rata between the preferred shareholders (exchanged) and the common shareholders.

NOW Venture Tech Ltd. in liquidation and the selling price is $6 million.

Assuming no declared and unpaid dividends and all other senior debt, e.g. B. employee wages, secured debts, etc., have been paid:

How much do preferred shareholders get?

They are initially paid $0.8 x 2 = $1.6 for each preferred share they hold.

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

This leaves $2 million ($6 to $4 million) to be distributed pro rata to preferred and common shareholders.

Therefore, the preferred shareholders get an additional $2 million x 2.5 / 7.5 = $666,666.

So a total of $4,666,666.

The common shareholders will receive a total of $2 million x 4 / 7.5 = $1,333,333.

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

Example B:

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

You get 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 (company preferred):

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

In other words, they initially receive twice the purchase price per share as common shareholders (ie the initial payment as in Examples A and B). Any remaining assets will then be distributed among them and the common stockholders until the preferred stockholders have received 4 times the purchase price per share (plus unpaid but declared payment and the initial payment). Any remaining assets thereafter will be distributed pro rata to all ordinary shareholders.

NOW, let’s do the math:

Aside from the sale price, since the maximum total amount the preferred shareholders can receive is limited to four times the purchase price per prize, in any case they will not receive more than 4 x USD 2 million = USD 8 million (whatever the sale price may be ). be).

What is the breakeven point for the selling price?

Let y be the break-even selling price:

(y – 4) (2.5 / 7.5) = 8 – 4

y = 16

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

Therefore, the sale price must be at least $16 million for the preferred shareholders to receive $8 million. If the sale price exceeds $16 million, they still only get $8 million because there is a cap on the maximum amount they can get.

For this reason, it is the Company’s preference to set a cap on the liquidation amount that preferred shareholders may receive.