In the venture capital world, the term liquidity preference refers to a clause in a term sheet specifying that, upon a liquidity event, the investors are compensated in two ways:
- First, they receive back their initial investment (or perhaps a multiple of it), and any declared but not yet paid dividends.
- Second, the investors and all other owners (e.g. founders, etc.) divide whatever remains of the purchase price according to their ownership of the firm being sold, etc.
Example:
A founder owns a firm which is valued at $100,000, and venture capitalists buy new shares for $50,000 (thus making the firm worth $150,000, and giving the VCs 33% of it).
Dividends of $20,000 for class A shareholders (i.e. the VCs) are declared, but not paid.
The firm is sold to a new owner for $400,000.
The venture capitalists take ($20,000) of dividends out, leaving $380,000.
The venture capitalists then take ($50,000) of their initial investment out, leaving $330,000.
The venture capitalists then take 33% of the money ($110,000), leaving 66% for the founder ($220,000).
The venture capitalists have made ($180,000) from a minnow investment of $50,000, a hefty 3.6 fold return.
