Start-Up Entrepreneur Series: Preferred Stock

In the Start-Up Entrepreneur Series, I will be taking a deeper look into some of the most common questions early stage founders face in putting together and operating their new businesses.  

The Start-Up Entrepreneur Series will be published each Wednesday morning until conclusion. For more information, check out www.hoeglaw.com or drop Rick a line at rhoeg@hoeglaw.com.

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Unless your new start-up is fully capitalized by its Founders, one of the first questions a new company must ask itself is “How are we going to fund this thing?”.

Last week we discussed the most common preliminary funding mechanism: “convertible debt“.  Today, we’ll talk a bit about the primary form in which institutions invest in start-ups: “preferred stock”.

Financing Term Sheet Deep Dive: Liquidation Preference

Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process.  In this series we’ll look to shed some light on the legal language contained in a financing term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both the Company and the Investor.  Check out an overview here.

Financing Term Sheet Deep Dive will be published each Monday morning until conclusion. For more information, check out www.hoeglaw.com or drop Rick a line at rhoeg@hoeglaw.com.

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If dividends are the interest paid on a standard loan, then the “liquidation preference” is the return of principal.  Together they form the economic spine of the stock (or other securities) sold to the Investor, and, as such, should be the primary focal point of negotiations related to the Company’s value.

Put simply, a “liquidation preference” is an amount of money which the Company agrees to pay to the holders of its preferred stock (or other securities being sold) prior to (or in “preference”) to all other funds it is to pay its other stockholders upon the Company’s sale (or “liquidation”).

Unlike in a standard bank loan, however, a “liquidation preference” can take many forms, some much more costly than others.