This article is a crosspost from SME Law.

The Liquidation Preference term is frequently used in fundraising rounds. It is a major economic term to be negotiated in the term sheet between the founders and the investors, and is arguably the preference of the preferred shares.

Definition of liquidation

A liquidation is the procedure according to which a company dissolves its business. Prior to such resolution, the company goes through a number of steps with the aim of settling all its financial obligations to third parties and distributing any excess assets to the shareholders. Such liquidation occurs with a trigger, which is commonly named a ‘Liquidation Event’.

Liquidation Events usually include:

• A merger or consolidation (other than one in which shareholders of the company own a majority by voting power of the shares of the surviving or acquiring company).

• Sale, transfer of all or substantially all of the assets of the company.

Liquidation Preference

In venture capital (VC) deals, the Liquidation Preference functions as a protection to the investors, granting them the right to get paid first when a Liquidation Event occurs.

1. The Participating Liquidation Preference ‘Double Dip’

In the Liquidation Preference with Participation, the preferred shareholders (ex. the investors) are eligible to receive the Original Subscription Price in addition to accrued dividends plus declared and unpaid dividends. Thereafter, the preferred shareholders will participate along with the ordinary shareholders (ex. the founders) on a pro rata basis in the distribution of the remaining assets. In effect, the preferred shareholder receive its invested amount first, the shares in whatever is left, if any.

2. The Non-Participating Liquidation Preference

In Liquidation Preference with Non-Participating, the preferred shareholder will only be eligible to receive the Original Subscription Price (which is the price of each share issued to the shareholder. It differs based on valuation) in addition to the accrued dividends plus declared and unpaid dividends. But this does not mean that the shareholder does not participate in the upside, because fundamental to such election is the preferred shareholders’ right to convert their shares to ordinary/common shares at any time. Therefore, if the liquidated assets after the satisfaction of third party obligations are equal to or less than the Original Subscription Price, the preferred shareholder will not convert, and will receive all the liquidated assets. If however, the liquidated assets less obligations are more than the Original Subscription Price (i.e the company was sold for a profit), the preferred shareholders will convert their shares to ordinary shares and receive Pro-rata a portion of such assets.

There are two more commercial terms that are commonly used in the Liquidation Preference and frequently negotiated between the founders and the investors and they are as follows:

1. The Multiple

In the Multiple, the preferred shareholders shall have the right to a multiple of the Original Subscription Price. This can be added to a participating or non-participating liquidation preference. For a better understating of this term, let’s assume the following:

• The investor invests $1,000,000 in a company and receive preferred shares.

• The pre-money valuation of the company is $3,000,000.

• The post-money valuation of the company is $4,000,000 (investment amount + pre-money valuation).

• This means that the investor will have 25 percent of the company’s share capital (investment amount divided by the post-money valuation of the company).

Case 1: The parties agree to a 2x Participating Liquidation Preference.

In this case, the investor will have the right to receive $2,000,000 (the investment amount x2) in addition to the accrued dividends plus declared and unpaid dividends, thereafter the investor will have the right to participate along with the ordinary shareholders (usually the founders) on a pro rata basis in the distribution of the remaining assets. So, if the Company had sold its assets and had $10,000,000 to distribute to the shareholders, the investor will receive $4,000,000 (2x investment amount + 25 percent of interest). If the Company had $4,000,000 to distribute to the shareholders, the investor will receive $2,500,000. If the Company had $2,000,000 to distribute, the investors will take it all.

Case 2: The parties agree on a 2x non- participating Liquidation Preference.

In this case, the investor will have the right to obtain USD 2,000,000 (the investment amount x2) in addition to the accrued dividends plus declared and unpaid dividends without participating with the ordinary shareholders in the distribution of the remain assets. Otherwise, they can elect to convert their preferred shares to ordinary shares, forgoes the liquidation preference and participate pro-rate.

If the Company sold its assets and had $ 10,000,000 to distribute to the shareholders, the investor can elect between remaining preferred shares and receiving $2,000,000, or convert and receive $2,500,000 (25 percent of $10,000,000) of course they will convert. If the Company had $4,000,000 to distribute, the investor will keep its preferred shares and receive $2,000,000.

2. The Cap

The Cap is designed to protect the founders and keep a balance between all the shareholders by putting a ceiling on how much the investor can receive.

Following the above example, the below demonstrates the use of the Cap in a Liquidation Preference clause.

Case 1: The parties agree on a 2x Participating Liquidation Preference with a 3x Cap.

In this case the investor will have the right to obtain $2,000,000 (the investment amount x2) in addition to the accrued dividends plus declared and unpaid dividends. Thereafter, will have the right to participate along with the ordinary shareholders on a pro rata basis in the distribution of the remain assets up to $3,000,000. However, their participation shall not result an amount more than $3,000,000 (the investment amount x3).

If the Company sold its assets and had $10,000,000 to distribute, the investor will receive $4,000,000 as the example before. But if had $20,000,000 to distribute, the investor will receive $5,000,000, only (2x investment amount + 25 percent of the rest with a cap of 3xinvestment amount). Without the cap, the investor would have received $6,500,000.

Conclusion

The Liquidation Preference is a major term in VC investments, and we highly advise all the founders to fully understand it and to appoint a counsel to negotiate it on their behalf. The Liquidation is not necessarily a disaster or unfair for the company, but if not negotiated, it can remove the incentive of the founders to sell early, and the cling on to a higher valuation.