Liquidation Preference is a multiple on the amount invested for a given round. An example of an exit event (e.g. the company is sold) provides for the easiest explanation. Let’s assume a company raised $2M on a $4M pre-money valuation. After the financing the investors own 33% of the company’s outstanding shares. However, if the company is purchased for $5M the liquidation preference becomes extremely important. In our example, we’ll use a liquidation preference of 2x.
We see on the right the two scenarios. The top chart shows the proceeds for the investor and founders if the investors put their money into common stock (where no liquidation preference exists). The chart below shows if the stock was Convertible Preferred Stock with a liquidation preference of 2x. With an exit amount of $5M, the 2x liquidation preference means that the investors receive 2x their initial investment of $2M for a total of $4M, before any money is provided to common shareholders. Therefore, the founders only receive $1M (the remaining money) of the $5M exit amount (thus 20%).
It is possible to try out different scenarios with the example to the right. Keep in mind, that the behavior of Convertible Preferred Stock is:
- to not convert to common, which means the liquidation preference is taken or
- convert to common and ignore the liquidation preference.
To see a scenario where the investor converts to common, set the Exit Amount to $12,100,000. At this point, the investor converts to common to receive 33.33% of the $12,100,000 exit instead of the 2x liquidation preference yielding $4,000,000. Up until $12,000,000, the investor will stay as preferred and utilize their liquidation preference. This is an illustration of down-side protection for the investor, which is the reason that liquidation preference exists.
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