The liquidation preference clause is of particular importance in the frame of venture capital transactions, because it determines the return that each investor will receive upon an exit of the company.
The liquidation preference clause applies when the venture capital fund exits the portfolio company through a liquidation event, a concept that typically includes the company’s liquidation, the transfer of all the company shares (by means of sale or merger) and the sale of the company’s business. In all these cases, certain proceeds are generated that, if it weren’t for the mechanics of the liquidation preference clause, would be distributed (directly or indirectly, depending on the type of liquidation event) among the shareholders in proportion to their holdings of shares in the portfolio company. A liquidation preference basically works as a downside protection of the invested capital in low-return scenarios.
In general terms, the aim of the liquidation preference is allowing the investor to recover the invested amount (or a multiple of the invested amount) with priority over the rest of the shareholders. There are three different types of liquidation preference:
• Non-participating, which grants the investors the right to recover an amount equal to their investment in the portfolio company or a multiple of it (for example, twice or three times the investment). After receiving the preferred amount, the remaining proceeds are distributed among the rest of the shareholders and, therefore, the investor does not participate in that distribution. This type of liquidation preference tends to be the most favourable to the founders of the company.
• Full participating, which gives the investors the right to recover their investment (or a multiple of it) and, in addition, to participate in the distribution of the remaining liquidation proceeds, on a pro rata basis with the rest of the shareholders. This type of liquidation preference is the most favourable to the investors of the company.
• Capped participating, which grants the investors the right to recover the amount of their investment with priority over the rest of the shareholders, and subsequently, to participate in the distribution of the remaining proceeds, on a pro rata basis with the rest of the shareholders, until a maximum amount is reached, which tends to be a multiple of the investment (usually between 2 times and 3 times the invested amount). Once the cap is reached, the funds will be distributed exclusively among the common shareholders, without the preferred shareholders participating in the distribution.
In high return scenarios, the non-participating and the capped participating liquidation preferences may result in the investors receiving less proceeds than what they would have received in case they would have participated in the distribution pro rata to their holding of shares in the portfolio company. For this reason, the investor will always have the right to voluntarily convert their shares into common shares, forfeiting their liquidation preference, and participating in the distribution on a pro rata basis with the remaining common shareholders.
Finally, it is important to take into account that the liquidation preferences generate the so called zones of misalignment or dead zones, in which the interest of the common shareholders and that of the preferred shareholders diverge, as a result of the operation of the liquidation preference.
• In the non-participating liquidation preference, the dead zone appears when the proceeds to be distributed are between the liquidation preference amount (1x, 2x…) and the amount that the investors would receive upon conversion into common shares. In that dead zone, the investors have no incentive to pursue an increase in the exit price, since their return remains flat, while the founders do actually benefit from such rise of the exit proceeds.
• In the full participating liquidation preference, there is no dead zone, which means that the interests of both parties are always aligned. Once the investors have received their liquidation preference, to the extent they subsequently participate in the distribution of the remaining proceeds, the investors will always increase their return and will never be interested in receiving the distribution on an as-converted basis.
• In the capped participating liquidation preference the situation is a combination of the previous two. The interests of both parties are aligned until the moment the investors reach their capped participation in the distribution of proceeds. Once the investors reach that cap, the dead zone reappears, and investors remain indifferent to the valuation of the company (since their return remains at a standstill), while the founders increase their liquidation proceeds as the amount to be distributed keeps rising. The turning point (which aligns investors and founders) takes place at the moment the investors would receive a higher return by converting their shares into common, rather than maintaining their liquidation preference.
The dead zones are increasingly more complicated when the company goes through additional financing rounds and when new investors in those rounds have priority in the distribution over the previous investors and, obviously, over the founders. That is why it is important to take into account these aspects when negotiating the liquidation preference clauses and always seek a balance between the interests of investors and founders.