The term refers to the certain privileges that a class of shares are provided over other classes of shares. As the name suggests, it provides a preference to a certain class of shares over other classes of shares. This is usually a standard term in shareholder agreements and the shares in later rounds are generally considered senior shares because they are at the top of the liquidation preference stack.
For example, if the company has raised a total of $200 million in all rounds and the last round was Series D and it raised $100 million in the last round. Now if the company is sold for say $150 million then series D shareholders will get their 100% of their investment back. Similarly, if series C shares invested $50 million then they also get 100% of their investment back and nothing is paid to Seed, Series A, Series B and common shares.
Liquidation Preference clause generally works differently in different scenarios.
Scenario 1 – Raising Fresh capital in subsequent round – Generally a liquidation preference clause in the fresh investment round would dilute the liquidation preference of the earlier classes of shares and put the new investor at the top of the stack.
Scenario 2 – Going for M&A – Generally in an M&A scenario, the investor in the latest round would tend to gain due to its liquidation preference over other classes of shares. This scenario is explained in the above example.
Scenario 3 – Going for IPO – If the company is going for IPO then all classes of shares are converted to equity shares and then the liquidation preference clause is diluted for everyone. Generally, in this case the investors of earlier rounds would tend to gain over later investors.
As we can see that the liquidation preference clause can have different impact in different scenarios. Hence, this clause has to be carefully drafted in the shareholders agreement so that the interests of all parties can be taken care of.
As a valuer, this clause needs to be studied for different classes of shares and based on the purpose of valuation, its impact should be considered. Hence, the value of all classes of shares cannot be the same if they have different liquidation preferences.
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