Liquidation Preference in Venture Capital Deals

What is Liquidation Preference?

A Liquidation Preference provision sets out the level of priority that an investors’ shares receive for the purpose of recovering their initial investment (or a multiple thereof) upon trigger of a liquidation event. A liquidation event typically includes winding up, sale of substantial assets of a company, change of control, merger, acquisition, reorganization and other corporate transactions, among others.

How Liquidation Preference Helps an Investor?

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Types and Mechanics of Liquidation Preference

Types of Liquidation Preference

*Note:The multiple on the liquidation preference may be more than 1x and the amount of distribution of the liquidation preference shall be determined basis such a multiple.

Let us understand the mechanism of different types of liquidation preference through the below illustration:

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Scenario 1: Non-participating liquidation preference

1x or pro rata, whichever is higher

*Note: The total liquidation proceeds are the total proceeds from a liquidation event which are subject to distribution between the shareholders.

2x or pro rata, whichever is higher

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This form of liquidation preference is most desirable as, while it allows the investors to recover their initial investment, it also enables them to take advantage of the upside in case the larger proceeds are accumulated from a liquidation event.

It is however, not recommend signing up for a multiple on the investment amount.

Scenario 2: 1x (participating liquidation preference)

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While this may seem like a desirable form of liquidation preference, in the event the structure of a liquidation is not pari passu, i.e., in case the liquidation clause provides for a seniority, this may lead to disadvantage to the holders of equity shares (in most cases, the founders).

Conclusion

In conclusion, while liquidation preference is a crucial right for the investors, it is important for the founders to be mindful about the construct of this provision.

Early stage founders are recommended to consider the 1x non-participating liquidation preference, preferably provided in Scenario 1. Excessive or stringent liquidation preferences can deter future investment rounds and put the founders at risk of reduced share in the liquidation proceeds.

About the Author

Darshana Chauhan

Senior Associate | darshana.c@treelife.in

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