How do you value your common stock options when there is a liquidation preference overhang?

1 What is a liquidation preference overhang?

A liquidation preference overhang is the amount of money that the preferred stockholders are entitled to receive before the common stockholders in a liquidation event. It is usually expressed as a multiple of their original investment, such as 1x, 2x, or 3x. For example, if the preferred stockholders invested $100 million at a 2x liquidation preference, they would get $200 million before the common stockholders get anything. The liquidation preference overhang can create a gap between the valuation of the company and the amount of money available for the common stockholders, especially if the company is sold for less than its valuation.

2 How does a liquidation preference overhang affect your common stock options?

A liquidation preference overhang affects your common stock options by reducing or eliminating their value in a liquidation event. If the company is sold for more than the liquidation preference overhang, then the common stockholders will get the remaining amount after the preferred stockholders are paid. In this case, your options will have some value, but it will depend on the price per share and the exercise price of your options. However, if the company is sold for less than or equal to the liquidation preference overhang, then the common stockholders will get nothing, and your options will be worthless. This is called a "down round" or a "washout".

3 How can you estimate the value of your common stock options?

Estimating the value of your common stock options requires knowledge of the company's valuation, capital structure, liquidation preference, and exit scenario, as well as the number of shares, exercise price, and vesting schedule of your options. To do this, you can follow these steps: first, find out the company's valuation and amount of money invested by preferred stockholders; second, determine the liquidation preference of preferred stockholders and liquidation preference overhang; third, ascertain the exit scenario of the company and price per share of common stock; fourth, calculate the value of your options using a formula; fifth, adjust the value for liquidation preference overhang with another formula; and finally, compare the adjusted value to your exercise price to decide whether to exercise or not.

4 Here’s what else to consider

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