![]() ![]() In addition to receiving a right to liquidation preferences, preferred stockholders also hold a voluntary conversion right that allows them to convert their preferred shares into common shares at any time. Liquidation preferences can influence investor returns for any type of exit other than an IPO 3. Thus, liquidation preferences can play a critical role not only in downside scenarios like bankruptcy, but also in upside exits like a lucrative acquisition. In the venture capital (VC) industry, however, investors use a broader definition of liquidation event that encompasses not only bankruptcy, but also acquisitions and changes of control 2. In most business settings, the phrase liquidation event refers to bankruptcy proceedings. Investors include liquidation preference clauses within term sheets as downside protection in case the startup’s exit (commonly referred to as a liquidation event) is below expectations. Once creditors have been paid in full, liquidation preferences determine how much of the remaining amount goes to preferred stockholders and how much goes to common stockholders (held by founders and employees). As mandated by corporate law, creditors receive any capital resulting from the liquidation event until 1) they have recovered their entire investment or 2) they have exhausted the proceeds from the liquidation event. Liquidation preferences represent a right to receive proceeds from a liquidation event before other shareholders. ![]() This article explores the mechanics of liquidation preference calculations and the most commonly used variations. Many people in the startup community 1 consider liquidation preferences to be the second most important aspect of a financing arrangement, preceded only by the valuation. As you consider the impact of these shareholder rights, you should pay close attention to the liquidation preferences offered in the deal. Many of these rights can significantly change the economics of a proposed investment and alter the return founders will receive during an exit opportunity. During equity funding rounds, preferred stock investors receive additional rights not granted to common shareholders. ![]()
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