Liquidation Preference
Liquidation preference is core to venture capital. It defines terms for what will happen to the investment if a company goes through a liquidity event, such as acquisition, merger, or wind-down, and can offer investor protections, no matter what the outcome is at exit. This glossary defines liquidation preference, why it matters, and the impact on exit scenarios.
What is a Liquidation Preference?
A liquidation preference is an essential term for any investor to know and to discuss in negotiations to protect their investment at the early stages of funding rounds, in case a down round occurs that continues in a downward slump and leads to liquidation.
The liquidation preference is a contractual right that allocates investors preferred shareholder status, allowing them to receive a payout before common shareholders if there is a liquidity event. It protects investors’ capital by setting repayment to them for their original investment as a priority before payment of debts or value going to common shareholders, even if common share value dilution occurs.
There is a significant difference between return on investment, such as a 1x preference, and multiples, such as 2x or higher. These multiples offer further protection to the investor by guaranteeing their return of a multiple of their original investment, whatever the exit outcome.
Why Liquidation Preference Matters in Venture Capital
Liquidation preference is an essential term for all investors to know because it protects against downside risk by ensuring that investors receive their repayment before founders or employees. The risks are higher in early-stage funding rounds, so this is where liquidation preference clauses are most essential to bring up for discussion.
In the past, liquidation preference usually favoured investors. As a result, founders grouped and decided to negotiate better terms for themselves and their employees at the expense of investors.
It’s worth bearing this in mind when going into negotiations for liquidation preference as an investor, because you need to agree on the best terms for you, but must be aware that these terms can create tension around equity distribution.
The other reason liquidation preferences are negotiated so intensively is that founders are aware that they form such a critical part of preferred stock agreements, which favour investors during exit scenarios.
How Liquidation Preferences Affect Exit Scenarios
Liquidation preferences are crucial for investors because they determine the amount they will receive in a liquidation event. One of the biggest factors to agree at the negotiation table with founders is whether investors receive participating or non-participating liquidation preferences because of how heavily these different clauses affect exit scenarios.
Participating and non-participating liquidation preferences vary drastically:
- Participating liquidation preference: Investors reclaim their investment first, then share remaining proceeds with common shareholders. This clause is lower risk but lower reward for investors.
- Non-participating liquidation preference: Investors choose either return of investment or conversion to common stock for profit, offering more flexibility, protection, and opportunity for profit.
It’s essential to negotiate the right liquidation preference clause for investors because this clause will heavily influence decisions at the exit stage in a liquidation event.
Liquidation preference is a critical mechanism for shaping investor returns and equity because it is impossible to predict the trajectory of a startup, and a post-money valuation is always a prediction. The liquidation preference clause is one of the best examples of how investors need to make the right decisions to protect their investment by balancing risk and reward in their venture capital investments.
The best investor approach is careful negotiation and clarity at the agreement drafting stage to avoid conflicts during liquidity events.