Continuing with our Wednesday term sheet focus, one of the clauses which received quite some attention in the term sheets I saw last year was the liquidity preference.

To explain that with an example, let’s assume a venture capital investor invested £5 million in a firm with a post-money valuation of £20 million and received preference shares with a 2x liquidity preference. Two years later, the firm has a buyer for a sale price of £50 million and management decides to exit. The investor will now receive an upfront £10 million before the rest of the proceeds are shared between the remaining participants.

If the VC in question had participating preference shares, they will also participate in the distribution of the remaining proceeds in proportion with their share holding.

In some cases, the VC holds what are called capped participating preference shares. These generally kick in when the exit is exceptionally high. In this case, the liquidity preference may be capped between 3x-5x. However instead of going the pref route, the VC may stand to gain more if they convert their preferred to common shares and have all the proceeds distributed across the shareholders according to their respective holdings.

Last year as the markets went through the recession, there were term sheets with some drastic liquidity preference clauses floating around. I think the only saving grace was to know that my European experience is also being reflected on the other side of the pond. Some Q4 2009 data from Fenwich and West:

The percentage of senior liquidation preference by series was:

 And what we see is a drop in Series B participating shares while there is an almost 25% increase in participating shares in Series C

The percentage of financings that provided for participating:

Of these financings, the percentage which were not capped

And the ranges of multiple preferences broken down are:

The preference multiple of 2x-3x actually rose to 43% in Q4 2009.

However from what I have been seeing and hearing, there are some friendlier terms in the market in Q1 2010. Would be interesting to see Fenwick and West’s Q1 report which should be coming soon.