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The VC Series – Liquidation Preferences

‘The VC Series’ is a series of articles aimed at founders who are thinking of raising funds from venture capital investors. Further information about The VC Series can be found here.

A liquidation preference is one of the key preferential rights that a VC is likely to require as part of its investment. This article explains what a liquidation preference is, and explores the different types of liquidation preference that are available.

What is a Liquidation Preference?

The liquidation preference determines in what order proceeds will be returned to shareholders on an exit or a winding up of the company.

In the absence of a liquidation preference, proceeds would simply be distributed among shareholders in proportion to their shareholdings.

A liquidation preference operates such that investors who hold preferred shares will have the right to get a certain amount of money back in priority to the other shareholders.

The amount of the preferred return is subject to negotiation but is typically an amount equal to the amount invested by the investor. Where a valuation is considered too high, an investor might require the liquidation preference to be a multiple of the amount it invested – this should though be strongly resisted by founders.

The preference therefore provides important downside protection for the investor in circumstances where the value of the company does not grow at the rate envisaged at the time of investment.

Different Types of Liquidation Preference

  • Non-Participating

This is where the investor has the right to recover an amount equal to their investment, or a multiple of it. Any remaining proceeds are distributed to the other shareholders in proportion of their shareholdings (meaning that the investor does not participate in this distribution). This type of preference is the most founder friendly.

In circumstances where this would lead to the other shareholders to receive a better return than the investor, then immediately prior to the sale the investor would be expected to convert its preference shares into ordinary shares, meaning that its liquidation preference would be forfeited and the proceeds would simply be apportioned to all shareholders in proportion to their shareholdings.

  • Full Participating

This gives the investor the right to recover an amount equal to their investment, or a multiple of it, and then also to participate in the distribution of the remaining proceeds pro rata with the rest of the shareholders. It is often referred to as a ‘double-dip’ preference.

This is the most favourable liquidation preference to the investor as it allows them to maximise their upside, as well as providing downside protection.

  • Capped Participating

This operates in the same way as a ‘full participating’ liquidation preference, but the investor would only be able to participate in the distribution of the remaining proceeds with the rest of the shareholders, until a maximum amount of return is reached (which is likely to be a multiple of the investor’s original investment).

Once the cap is reached, any remaining proceeds will be distributed to the other shareholders in proportion to their shareholdings.

Practical Tips for Founders

The structuring of a liquidation preference is a crucial element of a VC investment, and it is important that founders have properly modelled how it will operate in different scenarios before agreeing to anything.

This is particularly important where there have been multiple investment rounds and different investors have been granted different liquidation preferences, as it will be important for the founders to properly understand the amount at which the company will need to be sold before the ordinary shareholders can receive a return.

Whilst it is beyond the scope of this article, founders should also be aware of the possibility of the liquidation preference creating what are known as ‘zones of misalignment’ (also referred to as ‘dead zones’). This is where the mechanics of the liquidation preference can lead to a conflict of interests between the preferred shareholders and ordinary shareholders.

The VC Series – Next Article

The next article in The VC Series explores anti-dilution in more detail.

You can find details of all the different articles in the VC Series here.

If there is anything that we have not covered which you would find useful, then please let us know.

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