Type of Liquidation Preference
We have discussed briefly the various types of preferred stock here, and touched on the liquidation preference right. It is important to more that there are variations of liquidation preference structures and some structures are more “aggressive” toward the existing stockholders than others. Let’s review a simple example to illustrate why pre-money valuation is definitely not the only term to focus on:
Scenario A: a company raises $4M Series A Preferred at $6M Pre money valuation. The Series A Preferred is non participating convertible preferred. Following the investment the Series A owns 40% of the company.
Scenario B: a company raises $4M Series A Preferred at $8M Pre money valuation. The Series A Preferred is participating convertible preferred. Following the investment the Series A owns 33% of the company.
Presumably, scenario B is better for existing shareholders as it results in less dilution due to higher pre-money valuation. However less review closely the true effect of dilution that results from the liquidation preference right. We’ll assume the company receives an offer to be acquired for $20M:
Scenario A: being non-participating preferred, the series A stockholders will need to choose between receiving their liquidation preference of $4M, OR converting into common and participating with the common stockholders 40%-60% (in favor of common). Since 40% of $20M is $8M, clearly the Serie A stockholders are better off converting their shares into common.
Scenario B: being participating preferred, the series A will be receiving BOTH their liquidation preference of $4M, AND converting into common and participating with the common stock 40%-60% (in favor of common). In this case, the first $4M will go to the Series A shareholders, and the remaining $16M will now be split ratably between the Series A stockholders and Common stockholders such that the Series A stockholders will receive additional $6.4M (40% x $16M = $6.4M). In this scenario, total proceeds to Serie A stockholders is $3M + $6.4M = $9.4M.
We can see how liquidation preference impact greatly the amount of money left for other shareholders in he event of sale, and that a round with a lower “pre-money” is financial better to existing shareholders than a round with higher pre-money valuation.