# VC term-sheets: Liquidation preference + capped participation clarification

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I was reading "Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist " by Brad Feld and Jason Mendelson. It's a pretty good book but some parts aren't obvious, like the one below (Chapter4)

A company that has raised \$50 million where the investors own 60 percent and the entrepreneurs own 40 percent. Assume the company is being acquired for \$100 million.

(My clarification) Assuming a 1x preference levels (for preferred stock), we explore three scenarios for the participation levels (at liquidation) to determine the payoffs of the investors vs entrepreneurs. There are stipulated in the term sheet when the investors first made their investment to the entrepreneur.

Case 1 : 1× preference, nonparticipating: Investors get 60 percent, or
\$60 million, and the entrepreneurs get 40 percent, or \$40 million.

Case 2 : 1× preference, participating: Investors get the first \$50
million, and then 60 percent of the remaining \$50 million (\$30
million) for a total of \$80 million. The entrepreneurs get 40 percent
of the remaining \$50 million, or \$20 million.

Case 3 : 1× preference, participating with a 3× cap: Since the
investors won't make greater than 3× on this deal, this is the same
as Case 1
.

Case 1 and Case 2 make perfect sense. But for case 3, shouldn't that highlighted section read as "this is the same as Case 2 "? I mean, since the 3x cap (\$150 million) isn't hit, participation (in liquidation) should continue, right? Or am I missing something? Or a typo in the book?

Thanks
Sid

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http://altgate.com/blog/2008/05/how-liquidation-preferences-work.html For Case 3

1)the preferred amount will be \$50M + 60% of the remaining(\$100-\$50) = \$80M
(and also \$80M is less than \$150M(3x of invested \$50M))

2)the common amount will be 60% of \$100M = \$60M

so the VC will choose the preferred amount instead of the common amount

VC will get \$80M and entrepreneurs will get \$20M

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Sample Term Sheet Language from a post by Brad Feld:

"After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis; provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock."

Mark Suster has an excellent blog post on this topic here: http://www.bothsidesofthetable.com/2010/07/22/want-to-know-how-vcs-calculate-valuation-differently-from-founders/ and a corresponding This Week in VC video as well.

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Yes, you're right.

The 3x cap could mean, depending on how it's exactly drafted, that the investors are limited to 1x (\$50m) + 3x (\$150m) = \$200m or a total payout of 3x (\$150m).