When a venture capitalist invests his money in a company, he can request that a liquidation preference clause be included in the contract.
In this article we are going to explain what this clause consists of and what the fact of including it or not in the contract affects you if you are looking for financing for your startup.
What is the liquidation preference?
The liquidation preference allows venture capital investors to protect the value of their investment against other partners, especially in low-return scenarios.
This clause talks about how the money is distributed among the partners in the event of a liquidity event in the company, that is, a sale of a majority part of the company or an IPO.
In the event of one of these events, venture capital investors have the right to collect before the rest of the shareholders based on the conditions agreed in the agreement with the startup.
By applying this type of clause, two kinds of economic rights are created in the company between its partners: preferred partners and non-preferred partners.
What types of liquidation preference can I apply?
If there is no liquidation preference in the contract with investors, in the event of a liquidity or exit event, the resulting capital is distributed directly among the partners depending on their percentage of participation.
The inclusion of this clause in the contract is a protection mechanism that is usually applied in scenarios of low return for the investor, by which the investor makes sure to recover his investment or a multiple of it.
Depending on how this clause is applied, we can distinguish up to three types of liquidation preference.
If an event of liquidity or exit from the company occurs, investors have the right to recover an amount equal to their investment in the company or a multiplier of this (2x, 3x…).
When the investor has received the amount that he had invested, the remainder is distributed among the rest of the partners.
This type of liquidation preference is the most favorable for the founding partners of the startup.
2. Full participating
In the event of a liquidity or exit event, investors have the right to recover their investment or a multiple of it, in addition to the percentage of shareholding that corresponds to them in the distribution of the rest of the funds with the other partners.
This type of liquidation preference is the most favorable for investors.
3. Capped participating
In this case, the investor has the right to recover his investment or a multiple of it, in addition to his percentage of share capital of the rest of the funds up to a maximum amount.
Once this amount is reached, the remainder is distributed only among the ordinary partners.
This type of liquidation preference is an intermediate option between the two previous ones.
Let’s see what happens in each of the previous cases with a practical example.
Let’s imagine a startup with an initial capital of € 300,000 that is made up of two partners (A and B) with the same shareholding.
These partners negotiate a € 200,000 financing round with an investment partner in exchange for 20% of the startup.
Thus, the distribution of the share capital would be established as follows:
- Partner A 40%
- Partner B 40%
- Investor partner 20%
Suppose that a year has passed since the entry of the investment partner and a company enters the scene that makes an offer to purchase 100% of the startup for € 800,000
If there is no liquidation preference, the capital distribution would be made as follows:
- Partner A € 320,000
- Partner B € 320,000
- Investor partner € 160,000
As there is no liquidation preference clause, the investing partner would lose money, which for him is a very unfavorable case to which he will hardly want to expose himself.
Practical case with “non-participating” liquidation preference
If the investing partner has required the entrepreneur partners to include a “non-participating” liquidation preference for the amount equivalent to their investment in the partner agreement, the distribution is made as follows:
- Partner A € 300,000
- Partner A € 300,000
- Investor partner € 200,000
In this case, the entrepreneur partners return their capital to the investing partner and the remaining capital is reimbursed in equal parts.
In this way, the investor does not receive any kind of profit.
Practical case with “full-participating” liquidation preference
If the investing partner has required the entrepreneur partners to include a “full-participating” liquidation preference, the distribution will be made as follows:
- Partner A € 240,000
- Partner B € 240,000
- Investor partner € 320,000
In this case, it is the investing partner who takes most of the profit.
Practical case with “capped-participating” liquidation preference
If the investing partner has required the entrepreneur partners to include a “full-participating” liquidation preference up to € 250,000, the distribution would be made as follows:
- Partner A € 275,000
- Partner B € 275,000
- Investor partner € 250,000
As you can see, in this case the investment result is quite balanced for both the founding partners and the investor.
What should I do if an investor requests liquidation preference?
If you are a founding partner of a startup and you are negotiating the entry of a potential investment partner to your company, it is important that you understand how the inclusion of this clause could affect you if the investor requests it.
As you have already seen, in some cases it happens that the founding partners of the same come to receive nothing in the event of a sale of the company, so that the investing partner keeps all the capital.
At The Startup CFO we provide financial advice to startups and SMEs to negotiate these types of clauses in the financing rounds, so if you have a startup and are interested in having us, we invite you to contact us.