Calculating Liquidation Preference

As a venture investor / founder / banker / lawyer, you’ve likely heard the term Liquidation Preference (LP) - and that LP determines how the proceeds will be shared at the time of a liquidity event (M&A, change of control, etc). You’re likely also aware that LP is either non-participating (straight) or participating (commonly referred to as double-dip). Lastly, LP is usually stated as a multiple e.g. ‘1x straight LP’ means the holder of preference shares has the option to receive either a) 1x of capital invested OR b) participate pro-rata in the proceeds with common stock holders.

What’s less known is how exactly the LP math works. Recently, this topic came up in a portfolio company documentation discussion and I was surprised to learn that very few VCs (myself included) / founders / bankers / lawyers know exactly how to calculate LP. While the concept and theory is known to all, there are various nuances of calculating LP and practical application that are unclear to most. Some examples of these nuances are below.

  1. If the company is sold for less than capital invested, are the proceeds distributed pro-rata to capital invested or pro-rata to ownership?
  2. Is LP calculated for the total shareholding of an investor or applied per series of shares issued? Does it matter?
  3. If one investor elects to exercise LP (i.e. take the capital invested or a multiple thereof), how do other investors distribute the proceeds? Is it inter-se pro-rata with the founders? Or is it based on each investors absolute ownership %? Is this pro-rata share applied to the remaining proceeds (after paying of investors who elected LP) or is it applied to total proceeds? If one does the latter is there enough to distribute?
  4. Does one investors LP decision change the payoff for other investors? How?
  5. Does LP mean investors shares are ‘senior’ to founders shares?

...and many more.

I did some reading to get answers to these. While there are reams of articles dedicated to explaining the concept of LP, there aren’t actual LP calculation examples that clearly answer the above questions. So I thought I’d take a stab at this.

After several discussions with colleagues, other investors, lawyers and bankers, I think I’ve finally understood how this practically works. And I thought I’d share my learning with others by using an example of a company that has gone through 3 rounds of financing after which it is acquired. I’ve used different scenarios of the sale value ranging from the company being sold for less than capital invested, to the sale value being more than capital invested but less than the last private round valuation, to finally a scenario where the company is sold for greater than the last round valuation.

Please see the attached spreadsheet. The calculations are a bit involved so you’ll have to patiently walk yourself through the formulae to understand this completely. And if you think LP calculation is hard, wait till you see an Anti-Dilution spreadsheet :) that’s an article for another day!

Would be great to hear your feedback / questions on this. Thanks to Archana from Rajaram Legal for patiently reviewing versions of this till her eyes glazed over. Also, thanks to my friend and VC from Saif, Mayank who helped with this and also pointed me to a fantastic article by Charles Yu that cleared many of my doubts. Here’s the article for those of you interested.