GraduateTutor.com’s finance tutors teach venture capital and venture finance classes students encounter in their MBA programs. We cover the following topics related to liquidation preference on this page.
- What Is Liquidation Preference?
- How Does a Liquidation Preference Work?
- What does ‘Preference’ Mean in Liquidation Preference?
- What does ‘Liquidation’ mean in Liquidation Preference?
- What are the Types of Liquidation Preferences Typically Seen?
- What Is Liquidation Preference, Non-Participating?
- What Is Liquidation Preference, Participating?
- Liquidation Preference Clause Example/Practice Question
- Tutoring for Venture Capital and Venture Finance Courses
What Is Liquidation Preference?
Investing in start-ups is risky. The likelihood of losing your investment is high. Liquidation preference is one way to reduce investors’ risk. To protect an investor’s investment, the founders may make an offer, or the investor may seek protection through a liquidation preference clause.
How Does a Liquidation Preference Work?
A liquidation preference clause offers ‘preference’ to these investors in the event of a ‘liquidation’.
What does ‘Preference’ Mean in Liquidation Preference?
The investment contract defines the preference offered to the investor. There can be many kinds of preferences. The preference may be in the preferential order of payment. These investors should be paid first in the case of a liquidation. Or the preference may be getting paid more than your investments in specified events. For example, getting paid 1.5x (times) the investment, or 2x (2 times) the investment, or more. Therefore, we need to review the contract to understand the details and preferences offered to each class of investors.
What does ‘Liquidation’ mean in Liquidation Preference?
Just like the preference is defined in the contract, the liquidation is also specified in the clause. Liquidation refers to a specific condition or event detailed in the contract. The event can be the liquidation of the company, a sale of the company, or an IPO, etc. The preference described above is triggered when the liquidation event occurs.
What are the Types of Liquidation Preferences Typically Seen?
Liquidation preferences can be categorized into two additional types.
- Liquidation preference, non-participating
- Liquidation preference, participating
This categorization is based on any rights the investors have in addition to the preference defined above.
What Is Liquidation Preference, Non-Participating?
If the investors do not receive any payouts in addition to the payouts prescribed in the contract under the liquidation preference clause, the liquidation preference is referred to as liquidation preference, non-participating.
What Is Liquidation Preference, Participating?
If the investors receive any payouts in proportion to the share ownership in addition to the payouts prescribed in the contract under the liquidation preference clause, the liquidation preference is referred to as liquidation preference, participating.
Note. The contract should specify the method of computation and timing of the payments in more detail.
Liquidation Preference Clause Example/Practice Question
Sushil launched a new email startup investing $45,000 in savings in Jan 2015. By April 2015, friends and family invested $200,000 at a million dollar post money valuation. In December 2015 Sushil raised $250,000 from series A investors in return for a 10% stake in the company. In December 2016 Sushil raised another $250,000 from series B investors at a pre money valuation of $7 million.
In July 2020 the company was sold to Mailchimp for $3 million.
What are the returns achieved for each category of investors under the following conditions. (Provide returns in MoIC and IRR). Assume investments are in the first of mentioned months.
- Series A investors has no liquidation preference clause.
- Series A investors has a liquidation preference – non participating clause.
- Series A investors has a liquidation preference – participating clause.
- Series A investors has a full anti dilution clause and a 10% equity pool was introduced.
Tutoring for Venture Capital and Venture Finance Courses
GraduateTutor’s finance tutors offer live online one on one tutoring for Venture Capital, Venture Finance and related finance courses at the graduate level. Other topics we tutor on include anti-dilution clauses, growth vs. valuation, sustainable growth, etc. Please email or call us if we can provide you with finance tutoring for venture capital courses or any one of the other quantitative courses you will encounter in a b-school program.