This is the 5th post in a series of posts on understanding the basic terms of a “Term Sheet”. In this post we will talk about LIQUIDATION PREFERENCE. If you haven’t already check out my previous post it “HERE”.
In addition to the potential for preferred stock to receive dividends separate of common stock. Another reason for its preferred status is the liquidation preference.
Imagine the company going out of business you would eventually sell out all of the assets and still owe money to a bunch of people. In a simple case if there were no other bank loans, employee salaries etc. you would be obligated to first give the preferred shareholders there money (+ dividends etc.) and then if there is any left over the common stockholders would get what is remaining amount.
We are given a few options below which I will explain.
“In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows: “
“[Alternative 1 (non-participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred (or, if greater, the amount that the Series A Preferred would receive on an as-converted basis). The balance of any proceeds shall be distributed pro ratato holders of Common Stock.”
We are given a new type of preferred stock terms here called “Non-participating preferred stock” This option would mean that the investors cannot “participate” the same way as common shareholders. Upon a liquidation event this share class would be paid out the amount they amount they invested (usually 1x or 2x) plus any accrued and unpaid dividends.
If the liquidation/(or sale) value is high enough than it may be more beneficial for the investors to convert the stock to common stock and lose the preferred stock status. In this case the investors get to choose the greater of either taking their proportionate share of the common stock vs. keeping their liquidation preference of the preferred stock.
For example take a company, which its preferred investors put in $1million for 10% and common stock holders own 90%. If the company were sold for $100M the preferred stockholders would get $1 million. However, if the stock was converted to common stock they would receive $10 million, which is much more beneficial. The flip side of this is if the company’s value was only $800,000 the preferred shareholders would not convert and they would receive the entire amount.
Common stock holders prefer that investors receive non-participating preferred stock over full participating, as we will see why in the next section.
“[Alternative 2 (full participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.]”
In the full participating example, preferred stockholders essentially “double dip”. They are first given their original investment (1x, 2x etc.) plus accrued & unpaid dividends. Then after they are still entitled to their proportionate (pro-rata) share.
In the example above, the preferred shareholders would get investment amount (in this case 1x) of $1million plus the converted amount of $10 million totaling $11 million. In these cases things can get large. If there is compounding preferred interest along with 2x, or higher liquidation multiple things can get pretty substantial in favor of the preferred investors. That is the reason this option is most beneficial to the preferred investors. A slightly better option to the common stockholders would be as follows:
“[Alternative 3 (cap on Preferred Stock participation rights): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).]”
By placing the cap we limit the amount that the preferred shareholders get. If the value is high enough it may be more beneficial for the investors to convert to common stock. Similar to our example above lets imagine the following:
$1M investment = 10% preferred stock (1x) with a cap of (5x) the original purchase price.
If the company was sold for $100M
We would calculate this as
$1M to preferred shareholders
Plus 5x the original investment amount which is $5M
Equals a Total of $6M
In this case if the investors converted stock to common stock they would receive a greater interest.
Check out the Participating vs. non-participating spreadsheet to work out some of these models on your own.
“A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) and a sale, lease, transfer, exclusive license or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above [unless the holders of [___]% of the Series A Preferred elect otherwise]. [The Investors' entitlement to their liquidation preference shall not be abrogated or diminished in the event part of the consideration is subject to escrow in connection with a Deemed Liquidation Event.]“
Since this third option sometimes creates large “flat spots” where common stockholders could receive the same amount regardless of a range of valuations, this option clarifies and protects the preferred investors from this.
Liquidation preference can make a large difference and is particularly important to understand fully. You should consult with an expert to run out some various models with different pricing strategies.
In the next post 6, we’ll discuss “Voting Rights and Provisions”
“Having struggled initially to find simple explanations to some of these complex terms and concepts, my goal is to clearly walk you through this term sheet as well as other concepts for starting a successful startup. Please feel free to provide feedback, comments and categories for future posts.”
DISCLAIMER: This article and/or any attachments or links are intended to serve as informational purposes only. They should not be construed as legal advice for any particular facts or circumstances. You should consult with your legal team.