Liquidity preference (venture capital)

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:

1. First, they receive back their initial investment (or perhaps a multiple of it), and any declared but not yet paid dividends.
2. 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.