Anatomy of a Term Sheet: Liquidation Preference I

If ownership is the most important provision to an Investor in any term sheet, then the next most important provision is the liquidation preference. A liquidation preference (sometimes called the liquidation preference waterfall) sets out who gets paid (and how much) and in what priority in the event of a liquidation or “deemed liquidation” of the Company. 

The liquidation preference is payable, not only on a liquidation or winding up of the Company, but also on certain other “deemed liquidation” events, such as an acquisition of the Company or the sale of all or substantially all of its assets. You should also note that some Investors, will also require the liquidation preference to “pay-out” (usually by the further issue of shares) on an IPO. 

The amount of the liquidation preference is a function of risk. Typically, the amount of the liquidation preference is the amount invested by the Investor. For example, if the preferred shares were issued for £3.00 per share, a holder of one preferred share will receive £3.00 per share prior to any payments to the ordinary shareholders (a “x1 preference”). If the valuation is considered too high or the Company is inherently risky a higher multiple may be used. During the fall-out after the dot com boom, liquidation preferences of multiples greater than the subscription price were not unusual (multiples of x5 were not unheard of). It is important to note that the liquidation preference (along with the other provisions in the term sheet) will set a precedent for investment rounds to come. When negotiating the liquidation preference Companies and Entrepreneurs should be mindful of (i) the amount of the preference to be paid to the preferred shareholders (particularly if the Company is capital intensive), (ii) the priority of payments among the different classes of shares (although it is likely that any incumbent Investor will also have a say in this) and (iii) the extent the preferred shareholders should participate with the ordinary shareholders in the distribution of the remaining assets. The structuring of liquidation preferences is crucial. Investors always know where they are in the preference stack. It is surprising how many Entrepreneurs focus on the valuation without fully appreciating the impact of the liquidation preference. It is advised that Companies should always model the impact of the liquidation preference prior to signing any term sheet. A liquidation preference of £2MM, will not have much of an impact to most Entrepreneurs, however if the Company has gone through multiple investment rounds, with liquidation preferences greater than x1, then the amount that the Company must be sold for in order for the ordinary shareholders to receive a return may be very high. 

For example if a Company has raised £20MM of venture capital through three rounds of investment (Series A — £5MM with a x1 liquidation preference, Series B £7MM with a x1.5 liquidation preference and Series C £8MM with a x1.5 liquidation preference), the Company will have to sell for £27.5MM ((£5MM x 1) + (£7MM x 1.5) + (£8MM x 1.5))  before the ordinary shareholders will see a penny.

Companies and Entrepreneurs should also factor the impact of any cumulative dividends into any model. Cumulative dividends to the extent unpaid will also pay-out on any liquidation. This can have a significant impact to the economics of the ordinary shareholders on any sale of the Company. 

Companies are advised to model the liquidation preference in the event of a “down-round”. If the Company has difficulty modelling the liquidation preference, the Company’s lawyers should be able to put this together relatively easily.

The Anatomy of a Term Sheet series can be found in full here