Venture deals in IT: liquidation preferences

Hi! Let's continue our acquaintance with the basic tools and terms of venture deals in IT. Before you is the fifth article on the topic, in which my colleague, Anastasia Akulich, and I will talk about such a tool as liquidation preferences.

What are liquidation preferences?

Liquidation preferences are the right of an investor to receive first priority (i.e. before other participants in the startup) payments in the event of certain events.

Such events most often include:

  • sale of startup
  • sale of core startup assets
  • change of control in a startup
  • startup liquidation

The exact list of events is fixed by the parties in the binding documents of the transaction, which was discussed here. Special attention should be paid to this section in order to understand in which cases it is necessary to make payments in favour of the investor.

After the investor has exercised his right to priority payments, the remaining amount is distributed among the funders and other participants of the startup. Thus, this instrument is a safety cushion for the investor, which guarantees the return of the funds invested in the business. The investor will be able to both earn money (in case of a successful divestment of the business) and minimise his losses (in case of a startup "failure").

Types of liquidation privileges

There are two main types of liquidation preferences: participating and non-participating. The difference between them lies in the priority payments an investor receives when liquidation preferences are realised.

Participating liquidation preferences - a type of privilege where, upon the occurrence of any of the events, the investor has the right to both get back the amount of the investment made in the startup and participate in the proportional division of the remaining profits. This type of liquidation preferences is the most favourable for the investor, as he/she receives more.

A more favourable option for funders is non-participating liquidation preferences. In this case, the investor has the right to EITHER get the investment back, OR to participate in the distribution of profits. The choice is made by the investor himself, depending on what is more favourable: for example, he invested 2M in a startup, but the part of the profit that would have been due to him if the main product had been sold was 1M. In such a case, the investor would take back the amount invested. 

This or that variation is determined depending on the specific transaction and the investment strategy of a particular investor.

What is a multiplier?

In the deal document you can see a figure in front of the set liquidation preference: 1x participating, 1.5x non-participating, 2x non-participating etc. This figure is the multiplier.

A multiplier is a factor that multiplies the amount of liquidation preference. 

Let's take an example: an investor has invested 3M in your business. You have agreed with the investor on his liquidation preference as 1x non-participating. This means that if an event occurs (let's say the startup is sold), the investor will get 3M (i.e. what he invested). If you set the multiplier to 2 (i.e. 2x non-participating), the investor would receive 6M (2 x 3M).

Liquidation preferences at first glance seem to be a rather complicated mechanism, but we hope that we have been able to explain clearly what it is and how it works. As always, we recommend that you don't be afraid to stand up for your interests and discuss the best liquidation preferences option for both parties with your investor. 

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