Liquidation Preference 101
Let’s assume you founded a biotech company and closed your first financing round. To keep it simple, let’s say the investors value your company at $5 Million premoney and invest $5 Million, which results in a $10 Million postmoney valuation. In return for their investment the investors receive 50 percent of the company in preferred stock (PS). Whereas you keep the remaining 50 percent in common stock (CS).
Preference indicates that in the event of liquidation such as an exit event the holders of PS will be paid in preference to holders of CS. The preferred stockholders can either exercise their liquidation preference or convert their PS into shares of CS at a predetermined ratio. The liquidation preference is determined by the following three factors:
Preference (usually 1x — 3x the investment): The amount of money the investor gets paid back before CS gets paid back
Participation (yes/no):Determines how the investor participates after his exercised preference
Cap (usually up to 5x the investment): The maximum amount of money the investor will be compensated
Below you see different exit scenarios. Spoiler alert: The payout profile greatly varies between the different liquidation preferences.
