How does liquidation preference work?

I just received a term sheet for a Series Seed preferred share deal.

Under Liquidation Preference it says: “In the event of an Exit (..), at the option of the Investors: (i) payment of 1x the Investment increased by a percentage of 5% per year, the remainder pro rata to be divided between the Ordinary Shareholders; or (ii) the proceeds are divided among all Shareholders on a pro rata basis in accordance with the nominal value of their Shares.”

Hmm.

Let’s translate this into a spreadsheet.

Picture1

Big Exit

Assume a $10m exit.

That means that the founder, the Series Seed investor and the Series A investor can divide $10m among themselves.

However, with a liquidation preference LIFO (last in-first out) applies. So the Series A investor gets his share of the exit value first. Then the Series Seed investor. Then the founder.

Additionally, because of the liquidation preference, the Series A investor can choose between either (i) 1.0 * $1.5m * 1.05 ^ 4 = $1.8m or (ii) 938 * $4,571 = $4,3m.

Obviously he will choose to get $4,3m.

Picture2

Now there is $10m – $4.3m = $5.7 left to divide among the founder and the Series Seed investor.

Because of the liquidation preference, the Series Seed investor can also choose between either (i) 1.0 * $220k * 1.05 ^ 5 = $255k or (ii) 250 * $4,571 = $1.1m.

He will choose to get $1.1m.

Therefore, I am left with an exit of $5.7m – $1.1m = $4.6m.

Small Exit

Now assume a $2m exit. That means an exit price of $2m / 2,188 = $914 per share.

The Series A investor can choose between either (i) 1.0 * $1.5m * 1.05 ^ 4 = $1.8m or (ii) 938 * $914 = $857k.

He will choose to get $1.8m.

Picture3

There is $2m – $1.8m = $177k left to divide among the founder and the Series Seed investor.

The Series Seed investor can choose between either (i) 1.0 * $220k * 1.05 ^ 5 = $255k or (ii) 250 * $914 = $229k

He will choose to get $255k.

However, since there is only $177k left that is what he will get.

I am left with an exit of $177k – $177k = 0. Zero. Nothing.

Huh.

Exit Range

If I chart this for a range of exit values:

Picture4

So the exit value has to be at least $2.1m before I see any money at all.

And not until an exit of $4.3m or more do I get my full pro rata share of # shares * exit price/share.

OK, now I get how liquidation preference works.

 

This post only discussed the liquidation preference commonly used in The Netherlands. Sjoerd Mol wrote a very interesting, more extensive post on liquidation preferences.

Thanks to Hans Westerhof and Chretien Herben.

Joachim Blazer is founder at Venture Value. Contact him at joachim@venturevalue.com.

Venture Value does startup valuations for founders who want to raise money with an investor.