What is "liquidity preference"

In macroeconomic theory, liquidity preference refers to the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds (here, the term "bonds" can be understood to also represent stocks and other less liquid assets in general, as well as government bonds). Interest rates, he argues, cannot be a reward for saving 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 saving, interest, in the Keynesian analysis, is a reward for parting with liquidity. According to Keynes, money is the most liquid asset. Liquidity is an attribute to an asset. The more quickly an asset is converted into money the more liquid it is said to be.

According to Keynes, demand for liquidity is determined by three motives:

1. the transactions motive: people prefer to have liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income: the higher the income, the more money demanded for carrying out increased spending.
2. the precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demanded for this purpose increases as income increases.
3. speculative motive: people retain liquidity to speculate that bond prices will fall. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).

The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. The supply of money together with the liquidity-preference curve in theory interact to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied (see IS/LM model).

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.

Category:Venture capital