Liquidation Preference in Subsequent Financing Rounds - Explained
How does the Liquidation Preference Affect Subsequent Rounds?
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Liquidation Preference in Series B Rounds
Preferred shares with a liquidation preference in a seed or series A round will generally be the only preferred class of shares issued. The liquidation preference and its priority may become an issue with later rounds of investment. Series B investors will want priority or equal participation rights with the series A preferred shareholders. The series A preferred shareholders may fight this and cause issues in negotiating a funding deal. Further, the terms of the series A liquidation preference may be generous (e.g., 2x or 3x multiple), such that it would greatly burden the common shareholders to give the same level of preference to subsequent investors.
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- Example: Series A shareholders invest $1 million with 2x liquidation preference. The first $2 million of proceeds from sale are accounted for. If a series B investor receives a 2x liquidation preference on a $15M preference, then the first $32 million from a sale or exit is promised to investors. The common shareholders stand very far down the line in priority of payment. If investor push an exit event that does not result in a huge valuation, then the common shareholder could receive very little for their work and effort.
A common method of dealing with series A investors in later stage funding is to cram down their rights. This means that the earlier investors preferred shares are exchanged for the new preferred class of shares. The series A investors will only go along with this is if the series B funding is part of an up round and stands to produce far greater value for all shareholders involved.
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