3. Liquidation Preference

The deal terms that are summarized under the term sheet sections "Liquidation Preference" and "Optional Conversion" define how the proceeds of the company are split between the various types of stockholders. As the titles of the two sections already suggest, the key issues are:

  • Whether or not the investor's financial claims receives preferential treatment in the case of a liquidation of the company
  • To what extent the investor's claims can be converted into common equity.

 

The purpose of this section is to provide the necessary background knowledge to understand the relevant deal terms and, more importantly, how we can use these elements to make deals possible, align the incentives of the entrepreneur and the VC, and improve the subjective valuation of the deal for the two parties.

To do so, let us use the following simplified example:

An entrepreneur wants to bring her business idea to market. To do so, she needs a capital injection of 10 million today. According to her own valuation, the post-money valuation of the company is 30 million (the value of the firm after the capital injection). Expected exit is in 4 years. The entrepreneur approaches a potential venture capitalist. The VC likes the idea a lot. However, according to the VC, the post-money valuation is only 15 million. 

How to structure the deal? In the following sections, we look at the following four alternative possible deal structures:

  • Straight equity
  • Straight preferred
  • Convertible preferred
  • Straight preferred packed with common equity.

 

When discussing these alternative forms of financing, it is important to keep in mind that the investment horizon of the VC is typically limited to 5-7 years and that the VC will then want to exit the investment. As such, the term sheet puts a lot of emphasis on the exit value of the company and how that value is distributed between the entrepreneur and the VC. Thereby, the term sheet generally distinguishes between two types of exit:

  • Liquidation
  • Initial Public Offering (IPO).

 

Thereby, the term "liquidation" is very broadly defined and also generally includes mergers, consolidations, and various forms of asset deals. The typical definition of a  "Liquidation Event" in the term sheet is as follows:

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”) [...].

 

In the following sections, we mainly focus on such liquidation events.