What’s a preference clause in term sheets?

Here is another term from a term sheet that first-time founders need to know.

Liquidation preference clause: This is the clause that sets out how the early investors are rewarded for the risk that they have taken. This clause is triggered in case of a “liquidation” of a startup. What is a Liquidation event? It includes mergers, sales, acquisition, transfer of control of the company.

“Preference” is granted to early investors because they get “preferred” shares in return for their investment. What are the preferred shares? Generally, the shareholders of preferred shares have greater rights to the assets of the company over their common stock counterparts. Check out this link for more details on the difference)

A preference clause may look like this: “In the event of any liquidation or winding up of the company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per-share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).” (from Brad Feld’s excellent blog)

So what does that mean in practice?

1) Suppose a series A investor invests $1M and gets a 1x preference on her investment. Assume the startup company is acquired for $10M, then the investor receives $1M back first, before the common stock shareholders.

2) Suppose a series A investor invests $1M and gets a 10x preference on her investment. Assume the startup company is acquired for $10 M, then the investor receives the entire $10M, and the common stock shareholders get $0.00!

Situation two above is an extreme scenario that I have shown for effect. It rarely happens because early investors know that this kind of a preference clause will not motivate the founders and their teams to work their tails off on their startup. That is not what an investor wants! Smart investors will try and balance their need for returns with their need to keep the management and the team of the startup motivated enough to produce those returns.

The lesson for founders? Negotiate to keep preference as close to 1x as possible. Usually, you will end up in the 1x to 2x liquidation preference range. Please don’t sign up with investors who need more than that unless you are desperate for funding (I know, easier said than done!).

The “preference clause” operates in conjunction with the “participation” clause, and I will cover that in a later post.

Originally published at https://www.linkedin.com.