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Liquidation Preferences refer to rights built into the terms of a financial instrument that guarantee the holder the right to get back the money it has invested or some fraction or multiple of the money before other investors are paid. The most common liquidation preference in venture capital financings appears as a term in a convertible preferred stock description that gives to the investor the right to receive back its investment (or its investment and a designated return) when the company is liquidated before proceeds from the liquidation are paid to holders of common shares. Typically, liquidation events include sales of the business or mergers. In the most common convertible preferred stock liquidation preference, the holder of the convertible preferred stock must choose to receive its liquidation preference or convert into common stock and receive the pro rata share of the liquidation proceeds. If the company’s sale generates a value per share that exceeds the liquidation preference to the preferred shareholder, conversion can be expected. A more investor-friendly preference, referred to as a participating preference, provides the holder even more rights. When included in a convertible preferred stock, this preference gives the investor his money back on a liquidation event and then lets him share pro rata with other shareholders in dividing up the remaining proceeds from the liquidation event. Liquidation preferences are a favored tool of lead investors in down rounds. Frequently, they have been used with extreme preferences, such as three or six times investment, to compensate the investor of a troubled company for taking the risk of investing. Such structures can drastically diminish the value of the securities held by other investors and make it more difficult to attract additional capital. See: Down Rounds, Pay-to-Play, Participating Preferred Stock. |