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Let’s take an example, starting with the same assumptions as the previous lesson:
- VCs take 20% of the Company for a $2 million investment (post-money valuation of $10 million)
- The Company is sold for $5 million five years later
Option 1: VCS own “1X” Non-Participating Preferred Shares
The preferred amount is $2 million.
The exit proceeds are divided as follows:
| Proceeds ($M) | % of Total Proceeds | |
| VCs | 2 | 40% |
| Founders | 3 | 60% |
| TOTAL | 5 | 100% |
It now becomes clear how liquidation preference protects VCs against the Difference in Cost Base. In our earlier example, VCs lost $1 million. Thanks to the liquidation preference, they recoup their initial investment.
Note that Founders had originally sold 20% of their company, but get only 60% of the proceeds at exit (vs. 80%.)
Option 2: VCS own “1X + 15%IRR” Non-Participating Preferred Shares
After five years, the preferred amount ballooned to $4 million.
Formula: 2 * (1 + 15%) ^5 = 4
The exit proceeds are now divided as follows:
| Proceeds ($M) | % of Total Proceeds | |
| VCs | 4 | 80% |
| Founders | 1 | 20% |
| TOTAL | 5 | 100% |
This is worse for Founders as they now capture only 20% of the exit proceeds due to the liquidation preference parameters.
Note: this type of preference is rarely used before pre-IPO rounds, at least in the US.
Option 3: VCS own “1X” Participating Preferred Shares
This time, VCs not only take the preferred amount first (i.e., $2 million) but also their pro rata share of what is left (i.e., 20%).
The exit proceeds are divided as follows:
| Proceeds ($M) | % of Total Proceeds | |
| VCs | 2.6 | 52% |
| Founders | 2.4 | 48% |
| TOTAL | 5.0 | 100% |
This is considerably worse for Founders vs. the 1X non-participating scenario.
Here is the Liquidation Preference clause in the NVCA template. As you can see, there is another scenario with a cap on the participation rights (which is equivalent to a minimum return scenario).
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 rata to holders of Common Stock.]
[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.]
[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).]
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.]
What happens when a new layer of “liquid prefs” is added at each new round of funding? Why is VC called a “Go Big or Go Home” game?
Let us know in the Comments section below.
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