How to Calculate Liquidation Preference in a Startup Business Venture Capital Financing Term Sheet

What is defalcation preference?

Liquidation alternative refers to adopted shareholders’ rights to accept a assertive bulk for the adopted shares they authority in alternative to accepted shareholders in the accident that the aggregation goes into liquidation.

The ambit of defalcation alternative varies amid altered appellation sheets. Some may be acutely favorable to investors, some may be less. However, the purpose of defalcation alternative is such that in the accident a aggregation goes into liquidation, adopted shareholders will consistently get something aback for their adopted shares afore accepted shareholders get anything. In added words, they will consistently get added than accepted shareholders. It is accessible that accepted shareholders will get annihilation if the aggregation does not even accept abundant assets to achieve the alternative amount.

Example A:

Venture Tech Ltd. has 5,000,000 accepted shares outstanding.

In a Series A financing, Investors A invests $2,000,000 in acknowledgment for 2,500,000 Series A Adopted Shares (i.e., acquirement bulk per allotment = $0.8).

The appellation area of this Series A annular provides that:

In the accident of a defalcation event, the adopted shareholders will be advantaged to accept in alternative to accepted shareholders an bulk according to 2 times the acquirement bulk per share, additional declared and contributed assets (the “Initial Payment”). After the Initial Transaction has been fabricated in full, any assets actual shall be broadcast to the adopted shareholders (on an as-converted basis) and accepted shareholders on a pro rata basis.

NOW, Venture Tech Ltd. goes into defalcation and the auction bulk is US$6 million.

Assuming no declared and contributed dividends, and all added chief debts, e.g., employees’ wages, anchored debts, etc., accept all been settled:

How abundant will the adopted shareholders get?

They aboriginal get US$0.8 x 2 = US$1.6 for every adopted shares they hold.

Therefore, the Initial Transaction is US$1.6 x 2.5 actor = US$4 million.

This gives US$2 actor ($6 – $4 million) remaining, which shall be broadcast to the adopted shareholders and accepted shareholders on a pro rata basis.

Therefore, adopted shareholders will get a added US$2 actor x 2.5 / 7.5 = US$666,666.

I.e., a absolute of US$4,666.666.

The accepted shareholders will get a absolute of US$2 actor x 4 / 7.5 = US$1.333,333.

Total = US$4,666,666 + US$1,333,333 = US$6 million

Example B:

Following archetype A above, let’s say this time the auction bulk is US$10 million.

They will get a absolute of $4 actor (the Initial Payment) + $6 actor x 2.5 / 7.5 = $6 million

The accepted shareholders will get a absolute of $4 million.

Example C (company favored):

Let’s accord it a twist. This time aggregate is the aforementioned as aloft except that the absolute bulk the adopted shareholders will get for anniversary adopted allotment they authority is capped at 4 times the acquirement bulk per share.

In added words, they aboriginal get 2 times the acquirement bulk per allotment in alternative to accepted shareholders (i.e., the Initial Transaction as in Archetype A and B). All actual assets will again be broadcast a part of them and accepted shareholders until the adopted shareholders accept accustomed 4 times the acquirement bulk per allotment (plus contributed but declared payment, and the Initial Payment). All actual assets thereafter will be broadcast a part of all accepted shareholders on a pro rata basis.

NOW, let’s do the math:

Putting abreast the auction price, back the best absolute bulk the adopted shareholders can get is capped at 4 times the acquirement bulk per price, they in any accident will get no added than 4 x $2 actor = $8 actor (however top the auction bulk may be).

What is the breach even point for the auction price?

Let y be the breach even auction price:

(y – 4) (2.5 / 7.5) = 8 – 4

y = 16

Therefore, the breach even auction bulk is US$16 million.

Therefore, the auction bulk have to be at atomic US$16 actor for the adopted shareholders to get US$8 million. If the auction bulk exceeds US$16 million, they will still get alone US8 million, back the best bulk they can get is capped.

That’s why by ambience a cap on the defalcation bulk the adopted shareholders can get is company-favored.