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How Liquidation Preferences Work

TheFunded.com Advice

Posted by fnazeeri on 2008-05-14

Tags: Negotiation Terms Liquidation Preferences

PUBLIC:

Liquidation preferences are a key term in the definition of preferred stock (it's generally acknowledged to be the second most important economic term). Earlier, I wrote about this and other terms in a post on negotiating a term sheet, but here I want to give some specific examples to illustrate why this is such an important term.

You probably already know this, but it's worth repeating that liquidation preference refers to the procedure for paying investors off in a sale or winding up of the company. It typically includes two components: a preference (which is an amount that gets paid before others) and participation (the ability to "double dip"). Many folks have written on preferences in terms of definitions, so instead I'm going to give some simple examples.

For simplicity sake, imagine a VC has $10MM invested in one class of preferred stock in a company, owns 40% and the company is sold for $50MM. Here’s how the three different scenarios in my previous post work (in a specific example):

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