Liquidation preference

Definition of Liquidation Preference

Liquidation preference is a term used in the venture capital world to refer to the rights that investors have to receive a return on their investment before other equity holders or creditors in the event of a company’s liquidation.

This ensures that investors receive a certain amount of money from any proceeds generated from the liquidation of the company’s assets, regardless of their percentage ownership in the company. This preferential treatment is designed to make an investment more attractive to potential investors. 

Liquidation preference can also be used to reduce or increase the power of certain investors in a company, often those with the largest stake.

Understanding Liquidation Preference

Liquidation preference typically gives investors the right to receive their investments back before other shareholders receive any distributions. Accordingly, investors are more likely to provide capital to a company as long as they are assured of receiving their investment back before any other shareholder.  

Generally, preferred shareholders are paid first, and common shareholders are paid last. Investors typically receive a higher liquidation preference than founders, meaning they will receive a larger portion of the proceeds in liquidation or sale. 

So, it is important to discuss liquidation preferences with potential investors to ensure that expectations are clearly outlined and aligned. Investors have the right to negotiate liquidation preference and entrepreneurs should seek legal counsel to make sure they are fully informed on the terms of the agreement.

The liquidation preference also serves to protect the investor in the event of a “down round”, which occurs when the venture capital firm invests more money in the company at a lower valuation than the previous round. 

How Liquidation Preferences Work

Liquidation preferences typically come in two forms: participating and non-participating. Participating liquidation preferences allow investors to receive their money back plus a share of the proceeds from the sale of the company. Non-participating preferences only allow investors to receive their money back. Liquidation preferences are typically structured as a multiple of the original investment, such as 1x, 2x, or 3x the amount invested.

The Bottom Line

In conclusion, this concept is especially important for venture capitalists, as it ensures that they have a higher priority to receive a return on their investment compared to other shareholders. It’s also important to understand the terms of the liquidation preference before entering into an agreement so that you protect your investments in case of any downfall.