Liquidity preference

= Finance Theory =

John Maynard Keynes developed the Liquidity Preference of Interest in the General Theory of Employment Interest and Money. The primary consideration of the liquidity preference is the demand for money as an asset, as a means for holding wealth. Interest rates, he argues, cannot be a reward for savings as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless, refrained from consuming all his current income. Instead of a reward for savings, interest in the Keynesian analysis is a reward for parting with liquidity.

According to Keynes, demand for liquidity is determined by three motives:
# motive of transaction: people prefer to have liquidity to assure basical transactions, for their income is not constantly available. The amount of liquidity demande is determined by the level of income: the more income grow, the more demand is important.
# motive of precaution: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demended also grow with the income.
# motive of speculation: people retain liquidity to speculate. When interest rates decrease and are low, people think that it will soon increase, so that they keep money rather than investing it on financial market, because according to Keynes, when interests rates grows, the return of the investments in financial markets decreases, and "vice versa". Conversely, when interests rates are increasing and already high, people anticipate a decrease in it and an increase in the return of investment: they invest and do not demend for liquidity.

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 two ways:
# First, they receive back their initial investment (or perhaps a multiple of it), and any declared but not yet paid dividends
# 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 VCs then take $50,000 of their initial investment out, leaving $330,000
* the VCs then take 33% of the money ($110,000), leaving 66% for the founder ($220,000)

References

* [http://william-king.www.drexel.edu/top/prin/txt/money/QT7.html Liquidity Preference Curve]