What is the best liquidation preference strategy for an early stage VC?

Holders of preferred stock should expect to receive at minimum the market rate 1X liquidation preference when investing in early-stage companies. Participating Liquidation Preferences are sometimes referred to as “Double-Dip Preferred” and are most favorable to investors.

What is liquidation preference in VC?

The liquidation preference is perhaps one of the most important clauses found in a VC term sheet. A liquidation preference represents the amount the company must pay at exit (after secured debt, trade creditors, and other company obligations) to the preferred investors.

How common are liquidation preferences?

The most frequently used multiplier is 1. This means for each dollar an investor spends, he or she will get a dollar back in the event of a liquidation event. In fact, Cooley reports less than 10 percent of all VC deals have liquidation preferences in the last few years.

What is 2x liquidation preference?

A common formula would be that the VC has a 2x liquidation preference. This means that the VC gets to take double their original investment out of the company before any other shareholders get their first dollar.

Do convertible notes have liquidation preferences?

Convertible note liquidation preferences are the terms that define in what order shareholders will be paid should their convertible notes be liquidated at a liquidation event.

What are liquidation rights?

Liquidation rights determine the allocation of the proceeds when a start-up is sold. Because a sale is the most common form of exit for investors, these rights are a key factor in determining the return to investors, the return to the company’s management team and employees, and the incentives of all parties involved.

WHAT IS convertible preferred equity?

Convertible preferred stocks are preferred shares that include an option for the holder to convert the shares into a fixed number of common shares after a predetermined date. The value of a convertible preferred stock is ultimately based on the performance of the common stock.

What type of security does a VC fund typically hold?

We see probably about 60\% SAFE notes, 40\% convertible notes at the very early stage angel, seed and VC investments. The next type of security is preferred equity. So that’s that too and then the next one is preferred equity. This is what typically bigger VC investments are done in, and preferred has a couple features.

How does a 3x liquidation preference work?

It is possible that some investors are given up to 2x or 3x liquidation preference, which means they are entitled to a multiple of their original investment (double or triple) before common stockholders get anything.

What is a 1x non-participating preference?

Non-participating preferred: The investors receive their money back OR pro-rata distribution. Whichever yields more money to the investor. 1x participating preferred: The investor get their money AND pro-rata distribution. This is often referred to as “double dipping”.

What is a convertible debt offering?

A convertible note is a debt instrument that is convertible into shares of the issuer or another entity. They offer investors the downside protection of a debt instrument and the upside potential of an equity investment, but in return typically offer lower interest rates than straight debt instruments.

What are liquidation preferences in a VC financing?

Along with dividend rights, conversion rights, and anti‑dilution provisions, liquidation preferences are an essential economic term of the preferred stock typically sold in a VC financing. Liquidation preferences govern how a company allocates and distributes the proceeds from a sale, merger, dissolution, or other liquidation event.

What is the initial liquidation preference?

The initial liquidation preference entitles investors to a fixed per share distribution of liquidation proceeds before holders of common stock receive anything.

What happens to Series B investors when a company goes into liquidation?

This means that in the event of a liquidation, Series B investors will be paid back their full liquidation preference before Series A investors receive anything.

What is capped participation in liquidation preference?

After receiving the initial liquidation preference distribution, holders of a series of preferred stock with a capped participation feature will share in the liquidation proceeds on a pro rata basis with common stock until the agreed upon return cap is reached. Generally, the cap is a multiple of the original price per share.