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When a VC investor invests as part of a Series A or Series B round; they will often seek a Liquidation Preference with a Liquidation Multiple. This means they will get paid back first out of any proceeds in the event of a sale of the company.
The VC may get paid back many times their original investment (a Liquidation Multiple), before any other investor receives a Return. Usually the Liquidation Multiple is 1.0x. This means they will get their money back before any other investor gets a penny.
Why do VCs ask for this?
The Founders and early stage investors will know much more about the company before the VC invests; and will often stand to gain most if the company is really successful. And a VC's overall return across their fund can be heavily impacted by write-offs (investments that return nothing). The Liquidation Preference clause protects the VC on the downside, and motivates the Founders to shoot for a large outcome.
Did you know?: a Liquidation Preference will have no impact on the appearance of the Fully Diluted cap table, but can have a big impact on the overall returns to different investors. Particularly at low outcomes. That's why it's important to model the outcomes on a good cap table builder
- A VC invests $2.5m on a pre-money valuation of $5m, with a liquidation preference of 2.0x
- They get 33% of the company
- The company is sold for $4M
- The VC gets $4M (as this is less than their Liquidation Preference of: $2.5M x 2.0x = $5M)
- The Founders and other Investors receive nothing
- The company is sold for $12M
- The VC gets the first $5M (as this is their Liquidation Preference of: $2.5M x 2.0x = $5M) plus the remainder is split between the VC and the other Investors and Founders
- To see exactly how much they get, you may like to see our related guide on "Participating"
It's easy to model Liquidation Preferences, and see their impact using Reportally's cap table builder:
- Add a new equity round
- In the round option you'll see "Liquidation Preference": type in a liquidation multiple here, e.g. 1.0
- Click "Save" and you're done!
The Liquidation Chart will clearly show the impact of the Liquidation preference (the VC getting a return before all other investors); and the impact will also go into the Returns calculations.
Why not try it now - create a cap table and test the difference scenarios