This is the second round to cover up the terms in term sheet. The main subject is about liquidation preference, which is concerned with the division of the value when liquidity event – the sale of the company or the majority of the assets – occurs. Notice that liquidation preference is not about control, but utterly about money. It consists of two parts – the actual preference and participation.

Actual Preference

The actual preference is specified with the number which is the multiple of the original investment per share to be returned to investors in preference to the common stock holders. For example, if a series A investor invests $10m with 2x preference, then he will receive $20m in return when the company is sold. Occasionally the number goes higher than 1x, but in most case it is set to 1x.

Participation

Participation is another significant term in liquidation preference. It determines how the money shall be divided and delivered to investors. There are three options in participation.

• Non-participating: It is easy to calculate. In non-participating, the investor gets the pro rata amount of investment. For example, if the sale price is $100m and the investor has 40% of equity with $20m of original price, then the investor will get $40m, or 40% of $100m.
• Participating: Participating increases complexity on the event, yet the concept is simple. The investor may get the original investment price first, and then do calculation with the rest of the money. In the above example, in participating, the investor takes $20m – the original invement price – first and takes 40% of the rest of money, which is $32m or 40% of $80m. So the investor takes $52m in total.
• Participating with cap: Capped participation is a condition statement which indicates that a certain multiple return shall be reached. When the preferred doesn’t reach the cap, the fully participation is applied. See the example again, assuming that the contract is in participating with a 3x cap. As the return ($40m) doesn’t reach the cap ($20m x 3 or $60m), the result would be the same as the participating case. If the purchase price goes up to $200m that it makes better than 3x, the participation doesn’t happen.

Participation makes the deal more complicated because the other fundraising may follow up inevitably. Thus, it’s always better to simplify the liquidation preference especially in early days of business. That is, the entrepreneurs should choose the non-participating option for the future deal.