In the world of venture capital, one of the common methods for minimizing investor risk is liquidation preference.
But what is it, and how does it work?
Liquidation preference, a common tool included in a venture financing deal sheet, assures that, should the company be liquidated or sold, preferred shareholders will always get something back for their preferred shares before common shareholders get anything. The scope of liquidation preference varies between term sheets. Some deals are more favorable to investors than others. And some companies may even wish to include a cap on the amount preferred shareholders can receive should liquidation occur. Payment of the liquidation preference only occurs if there is a sale or liquidation of the company.
Liquidation preference is usually referred to as a multiple of the issue prices, such as “2x.” In this case, a holder of Series B Preferred Stock would be entitled to receive two times the issue price. Example: the purchase price of the preferred stock is $10 per share and the deal term calls for “2x,” the liquidation preference is $20 per share.
There are many levels of liquidation preference and it is important to determine who gets what in different exit scenarios. Liquidation preference is something about which even the most confident entrepreneur needs to be aware.