TL;DR
Liquidation Preference is a clause typically included in the terms of venture capital financing that specifies the order and amount of proceeds that preferred shareholders are entitled to receive, before any payments are made to common shareholders (usually founders, employees, and early investors).
This clause is activated in the event of a company’s liquidation, merger, acquisition, or sale.
The primary purpose of liquidation preference is to protect investors by ensuring that they recover their initial investment, and sometimes more, before the remaining proceeds are distributed to other shareholders.
This provision is especially important in high-risk investments like startups, where the likelihood of failure or suboptimal outcomes is significant.
How Does Liquidation Preference Work?
Liquidation preference works by giving preferred shareholders priority over common shareholders when a company is liquidated or sold.
Key aspects of liquidation preference include:
1. Preference Amount
The preference amount refers to the minimum amount that preferred shareholders are entitled to receive before any proceeds are distributed to common shareholders.
This amount is usually tied to the original investment made by the preferred shareholders and is often expressed as a multiple of the original investment (e.g., 1x, 2x).
- 1x Liquidation Preference: A 1x liquidation preference means that the preferred shareholders are entitled to receive 100% of their original investment before any proceeds are distributed to common shareholders. For example, if an investor put $5 million into a startup, they would be entitled to receive $5 million from the sale or liquidation proceeds before any other distributions are made.
- 2x Liquidation Preference: A 2x liquidation preference means that the preferred shareholders are entitled to receive twice their original investment before common shareholders receive any proceeds. In the same example, the investor would receive $10 million before any distribution to common shareholders.
2. Participation Rights
Participation rights determine whether the preferred shareholders are entitled to receive additional proceeds after their liquidation preference has been paid out. There are two main types of participation: non-participating and participating.
- Non-Participating Preferred: In a non-participating liquidation preference, preferred shareholders receive only their liquidation preference amount and do not participate in the remaining proceeds. After the preferred shareholders are paid, any remaining proceeds are distributed to the common shareholders.Example: If an investor has a 1x non-participating liquidation preference and the company is sold for $10 million, the investor would receive $1 million (their original investment), and the remaining $9 million would be distributed to the common shareholders.
- Participating Preferred: In a participating liquidation preference, preferred shareholders receive their liquidation preference amount and then also participate in the remaining proceeds alongside common shareholders, often on a pro-rata basis according to their equity ownership.Example: If the same investor has a 1x participating liquidation preference and the company is sold for $10 million, the investor would first receive $1 million (their original investment) and then share in the remaining $9 million with common shareholders based on their ownership percentage.
3. Cap on Participation
Some participating preferred shares may include a cap on the total amount that the preferred shareholders can receive.
For example, a 1x participating preferred with a 3x cap means that the preferred shareholder is entitled to receive their original investment back, plus additional proceeds up to three times their original investment, after which the remaining proceeds go to common shareholders.
Types of Liquidation Preferences
Liquidation preferences can be structured in different ways, and the specific structure can significantly impact the distribution of proceeds:
- Standard (Non-Participating) Liquidation Preference: This is the most straightforward type, where preferred shareholders receive their preference amount and no more. After their preference is satisfied, any remaining proceeds are distributed to common shareholders.
- Participating Liquidation Preference: This type allows preferred shareholders to receive their preference amount and then participate in the remaining proceeds, leading to a larger share of the total proceeds for the preferred shareholders.
- Capped Participating Liquidation Preference: This type of preference allows preferred shareholders to receive their preference amount, participate in the remaining proceeds, but with a cap on their total returns. Once the cap is reached, any additional proceeds go to common shareholders.
Why is Liquidation Preference Important?
Liquidation preference is important for several reasons:
- Investor Protection: Liquidation preference provides downside protection for investors by ensuring that they recover their investment before other shareholders. This is particularly important in high-risk ventures where the likelihood of a full return on investment is uncertain.
- Alignment of Interests: Liquidation preference can help align the interests of investors and founders by clearly defining how proceeds will be distributed in the event of an exit. This clarity can reduce potential conflicts and help facilitate smoother negotiations and decision-making.
- Impact on Valuation: The structure of the liquidation preference can influence the company’s valuation and the attractiveness of the investment. For example, a high liquidation preference or participating preference may make the deal less favorable for founders and common shareholders, potentially leading to more negotiation around the valuation.
- Impact on Exit Outcomes: The terms of the liquidation preference can significantly affect the financial outcomes for all shareholders in the event of an exit. In some cases, the liquidation preference can result in common shareholders receiving little to no proceeds if the company’s sale price is close to or below the liquidation preference amount.
Conclusion
Liquidation Preference is a critical term in venture capital deals that protects investors by ensuring they recover their investment before common shareholders in the event of a liquidation or sale.
Interested in learning more VC related terms? Head over to our VC glossary!