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Every start-up entrepreneur wants to create a start-up with rapid growth and that every euro invested returns at least ten. The investors expect the same, however, the reality is often different from the expectations.
In order to protect their investment, investors wish to include liquidation preference into the investment agreements.
However, it is important for a start-up founder to understand what this combination of words really mean, in order to avoid a situation where you would not only have the pleasure of doing business but would also have the proceeds from the exit shown in your bank account.
What is liquidation preference?
Liquidation preference refers to the right of an investor to recoup the money invested in the startup over other shareholders, mainly founders and employee shareholders but in some cases, preference will be given to some investors over others as well.
Essentially, liquidation preference determines the order of payments in case of a sale, liquidation or transfer of all assets of a company. The sale, liquidation or transfer of all assets of the company is referred to in the agreements as a liquidity event.
Why is liquidation preference necessary?
Liquidation preference is a form of protection for the investor. In the absence of a liquidation preference, the proceeds of a liquidity event will be divided pro-rata – proportionally to the shareholdings in the company.
Normally, the investor’s shareholding in the company is rather modest, so in case of a proportional distribution, the investor may end up receiving less than the investment amount initially invested in the company and thus losing money. In the case of the liquidation preference, this can be avoided.
How does liquidation preference work?
Liquidation preference is stipulated in the shareholders’ agreement and in the articles of association. Liquidation preference is determined primarily through a multiplier and helps calculate the amount to be repaid to the investor in preference to the other shareholders.
The most common and founder-friendly multiplier is 1x – in this case, the investor is repaid the investment amount and the proceeds exceeding the investment amount are to be distributed according to the agreement. However, it is not always possible to reach such a founder-friendly agreement, and multipliers greater than one are not uncommon.
In the case of the liquidation preference, it is possible that the investor reaps all the rewards and the founders will only have the process to enjoy but no monetary gains.
Let’s look at the following example:
The investor invested 5 million euros in the company and received 10% of the shareholding. The other 90% belongs to the founders and the proceeds of the liquidation event were 20 million euros.
In the case of no liquidation preference, the investor will receive 10% of the proceeds – that is 2 million euros – and the founders will receive 18 million euros. The investor, you can imagine, is not very happy in this scenario.
In case the liquidation preference was set at 1x, the investor would have received 5 million euros and the founders 15 million euros. The investor would be satisfied in this case and the founders would be content as well.
However, if the liquidation preference was set at 4x, the investor would receive all the 20 million euros and the founders will be left empty-handed. The investor would have made a nice profit on its investment and the founders only have their contract-negotiation skills, or the lack thereof, to blame.
Thus, in the end, it is important for both, the founder and the investor, to understand how liquidation preference works and the possible outcomes thereof.