## 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.

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.

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.

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:

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 author of The #1 Guide to Startup Valuation. How to value a startup in 6 easy steps. For founders and investors. For seed rounds and Series A.