How to Calculate Liquidation Preference in a Startup Business Venture Capital Financing Term Sheet
What is liquidation preference?
Liquidation preference refers to preferred shareholders’ rights to receive a certain amount for the preferred shares they keep up in preference to shared shareholders in the event that the company goes into liquidation.
The scope of liquidation preference varies between different term sheets. Some may be extremely popular 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 shared shareholders get anything. In other words, they will always get more than shared shareholders. It is possible that shared shareholders will get nothing if the company does not already have enough assets to settle the preference amount.
Venture Tech Ltd. has 5,000,000 shared shares noticeable.
In a Series A financing, Investors A invests $2,000,000 in return for 2,500,000 Series A Preferred Shares (i.e., buy price per proportion = $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 shared shareholders an amount equal to 2 times the buy price per proportion, plus declared and unpaid dividends (the “Initial Payment”). After the Initial Payment has been made in complete, any assets remaining shall be distributed to the preferred shareholders (on an as-converted basis) and shared 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 keep up.
consequently, 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 shared shareholders on a pro rata basis.
consequently, 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 shared 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
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 shared 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 proportion they keep up is capped at 4 times the buy price per proportion.
In other words, they first get 2 times the buy price per proportion in preference to shared shareholders (i.e., the Initial Payment as in Example A and B). All remaining assets will then be distributed among them and shared shareholders until the preferred shareholders have received 4 times the buy price per proportion (plus unpaid but declared payment, and the Initial Payment). All remaining assets thereafter will be distributed among all shared 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 buy 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 already point for the sale price?
Let y be the break already sale price:
(y – 4) (2.5 / 7.5) = 8 – 4
y = 16
consequently, the break already sale price is US$16 million.
consequently, the sale price must be at the minimum US$16 million for the preferred shareholders to get US$8 million. If the sale price exceeds US$16 million, they will nevertheless 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.