Liquidation preference: Why do investors need it, and how should founders work with it?
- 1. Liquidation event
- 2. There are non-participating liquidation preference and participating liquidation preference
- 3. Liquidation multiplier
Investing in a business always carries a risk for the investor. Therefore, when entering a company, they will ask you to provide protective tools to justify and secure this risk. In this article, we will discuss one of the instruments we see in almost every transaction – liquidation preference.
This mechanism allows the investor to recover their investment in priority over other shareholders in distributing the company's assets. The idea is to multiply the investment if the business succeeds and minimize losses if it fails.
In the turbulent world and business environment, this mechanism has become standard and is found in almost every transaction. The main thing is to agree on the terms so that all the parties are comfortable. For this purpose, we advise you to pay attention to the following points:
1. Liquidation event
This part lists the events that give the investor a right to a return on their investment. These may be the sale of a substantial part of the company's shares, a change of control, or the sale of most assets. All such events generally have a common outcome – the business sale to a new investor. It is also standard to include less happy scenarios – business termination (winding-up) when the company’s remaining assets are distributed among the shareholders. The founder needs to agree on these events in a clear and closed list to understand when the investor can exercise their preference.
2. There are non-participating liquidation preference and participating liquidation preference
Non-participating liquidation preference
Here, the investor has two options:
- return the original amount of their investment in the business, OR
- participate in the distribution of the company's assets on a pro-rata basis with all remaining shareholders.
The key point is that these options are not combined. The investor must choose one option based on what is more favorable for them.
Participating liquidation preference
There is no "or" here: after the investment amount has been returned, the investor is also entitled to participate in the distribution of the remaining assets and to take their pro rata interest in the company. So, the investor participates in the asset distribution twice.
3. Liquidation multiplier
The liquidation preference multiplier shows how much the investment amount increases: 1x, 1.5x, 2x, etc. The “2x” here means that, upon a liquidation event, the investor can request from the company an amount equal to twice their investment in the business.
After the investor has exercised its liquidation preference, the remaining amount is distributed among the other shareholders (usually pro rata).
For sure, the smaller the multiplier, the better for the founder. Also, a non-participating preference is more favorable for the founder than a participating one. But all of this is a matter of negotiations with the investor. We recommend weighing all sides of the liquidation preference mechanism in a bundle in negotiations, as well as in the light of all other instruments you plan to use in the deal – to balance the interests of the parties as much as possible and eventually come to a win-win result.
Dear journalists, the use of materials from REVERA website in publications is possible only after our written permission.
For approval of materials, please contact us by e-mail: i.antonova@revera.legal or Telegram: https://t.me/PR_revera.
