How to Calculate Liquidation Preference in a very Startup Business Venture Capital Financing Term Sheet
What is liquidation preference?
Liquidation preference identifies preferred shareholders’ rights for a specific amount for your preferred shares they hold in preference to common shareholders in case the business retreats into liquidation.
The scope of liquidation preference varies between different term sheets. Some may be extremely favorable to investors, some could be less. However, the goal of liquidation preference is really that in the event a business goes into liquidation, preferred shareholders will always get something back for their preferred shares before common shareholders get anything. In simple terms, they will always read more than common shareholders. Common shareholders may be certain to get nothing if the company won’t have enough assets to stay the preference amount.
Venture Tech Ltd. has 5,000,000 common shares outstanding.
In a Series A financing, Investors A invests $2,000,000 in substitution for 2,500,000 Series A Preferred Shares (i.e., final cost per share = $0.8).
The term sheet of this Series A round provides that:
In case of your liquidation event, the preferred shareholders are going to be entitled to get instead of common shareholders a sum comparable to 2 times the price per share, plus declared and unpaid dividends (the “Initial Payment”). After the Initial Payment has been made fully, any assets remaining shall be distributed to the preferred shareholders (on an as-converted basis) and common shareholders over a pro-rata basis.
NOW, Venture Tech Ltd. switches into liquidation and the sale costs are US$6 million.
Assuming no declared and unpaid dividends, and all other senior debts, e.g., employees’ wages, secured debts, etc., have got all been settled:
How much will the most preferred shareholders get?
They first get US$0.8 x 2 = US$1.6 for each preferred shares they hold.
Therefore, 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 preferred shareholders and common shareholders over a pro-rata basis.
Therefore, preferred shareholders are certain to get a further US$2 million x 2.5 / 7.5 = US$666,666.
I.e., an overall total of US$4,666.666.
The common 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 imagine this time around the sale costs is US$10 million.
They are certain to get an overall of $4 million (the Initial Payment) + $6 million x 2.5 / 7.5 = $6 million
The common shareholders are certain to get an overall total of $4 million.
Example C (company favored):
Let’s provide a twist. This time everything is similar to above apart from the exact amount the preferred shareholders are certain to get per preferred share they hold is capped at 4 times the price per share.
In simple terms, they first get 2 times the cost per share ahead of common shareholders (i.e., the Initial Payment as in Example A and B). All remaining assets might be distributed one of them and common shareholders until the most well-liked shareholders have received four times the purchase price per share (plus unpaid but declared payment, and the Initial Payment). All remaining assets thereafter are going to be distributed among all common shareholders on a pro-rata basis.
NOW, let’s perform the math:
Putting aside the sale price, since the maximum total amount the most well-liked shareholders can get is capped at 4 times the price per price, they, in any event, are certain to get no more than 4 x $2 million = $8 million (however high the sale price could be).
What is the break-even point for that sale price?
Let y be the break-even sale price:
(y – 4) (2.5 / 7.5) = 8 – 4
y = 16
Therefore, the break-even sale price is US$16 million.
Therefore, the sale price must be at least US$16 million for your preferred shareholders to acquire US$8 million. If the sale price exceeds US$16 million, they’ll still get only US8 million, since the maximum amount they can get is capped.
That’s why by setting a cap around the liquidation amount the most well-liked shareholders will get is company-favored.