The Essential Guide to Liquidation Preferences

Christopher A. Grew of Orrick, Herrington & Sutcliffe LLP

A liquidation preference gives the VC investor a "first right" to any proceeds available to shareholders in the event of a liquidation or trade sale of the company. Although a liquidation preference provides the VC investor with downside protection by giving them the first money out of the company that is paid to shareholders, it can also significantly increase the upside to an investment.

A non-participating liquidation preference means the preferred shareholders can get their investment back upon a trade sale or liquidation of the company, with the balance of the proceeds going to the holders of ordinary shares. If the ordinary shareholders would get more per share than the preferred shareholders under this approach, the preferred shareholders can voluntarily convert their preference shares into ordinary shares and share pro rata in the proceeds.

Most VC investments include a participating liquidation preference that permits the VC to receive their money back first in a trade sale or liquidation of the company, with the balance of the proceeds being divided amongst the holders of ordinary shares and preferred shares on a share-for-share basis. The participating preference is often referred to as a "double dip" because the VC investor receives their money back and then gets a share of the remaining proceeds.

A compromise between a non-participating preference and a participating preference is a capped participating liquidation preference. In theory, the benefit of a capped liquidation preference is that it allows the VC investors and the management to set a target value for a sale of the company below which the VCs reap the bulk of the return and above which the ordinary shareholders receive a substantial benefit. By using a capped liquidation preference, VC investors can provide an additional incentive to management to increase the value of the company. VCs can also avoid the seemingly unfair allocation of proceeds under a straight preference where the value of the company declines after the investment. There are numerous methods of implementing a capped liquidation preference, including:

  • A typical capped liquidation preference comprises an initial payment of the preference to the VC investors, after which the VCs participate pro rata with the ordinary shareholders on a pro rata basis until the VCs receive a certain specified return (normally between two to five times their original investment, with earlier rounds usually having the higher multiples).
  • After payment of the capped liquidation preference, the ordinary shareholders are entitled to share all remaining proceeds amongst themselves.

  • A variation of the above capped liquidation preference comprises an initial payment of the preference to the VC investors, after which a payment of a similar liquidation preference is distributed to the ordinary shareholders on a pro rata basis, and then the preferred shareholders begin to share again on a pro rata basis with the ordinary shareholders (either with a cap on the return to the VC investors or not).
  • A further variation is for the preference to disappear altogether (or be reduced) upon either a specific value being achieved in the sale of the company or at a specific date. The determination of the specific value is based upon the pro rata distribution of the proceeds to all shareholders being sufficiently large to ensure that all shareholders (including the preferred shareholders with a liquidation preference) receive an ample return on their investment.

In recent years, VCs have insisted upon multiple liquidation preferences: whereas a 1x liquidation preference would give a VC a preference equal to their original investment, in today's market it is not uncommon to see VCs demanding 2x or even 3x liquidation preferences. However, multiple liquidation preferences can backfire if they cause an "overhang" of investor preferences that may be too large to provide any meaningful return to management or the other shareholders (particularly in the context of a trade sale at a price that is less than the aggregate liquidation preferences of the preferred shareholders). In several recent instances, the VCs have been obliged to waive their liquidation preference in a follow-on investment to ensure a successful new round of investment (and a properly incentivised management team) or to "cut" the ordinary shareholders into the deal by allocating a portion of the trade sale proceeds to them (despite the fact that the ordinary shareholders may not be entitled to anything).

Finally, a liquidation event is usually defined to include a trade sale or merger of the company, in addition to a true liquidation or winding up of the company. Lately, however, some European VCs have insisted that a liquidation event also include an initial public offering. In theory, an IPO should not trigger a liquidation preference as a company should only go public at a valuation that would enable all shareholders (regardless of any preferences) to receive a more than adequate return on their original investment. Given the current state of the capital markets, it is unlikely that a liquidation preference will be utilised in the context of an IPO for some time.

Christopher A. Grew, Partner, Orrick,

Chris Grew, a partner in the London office, is a member of the Emerging Companies Group, which advises emerging companies and venture capital firms. Chris joined Orrick in 2008.

Mr. Grew advises technology companies in venture capital transactions, public offerings and cross-border mergers and acquisitions. He regularly advises high technology (particularly Internet and computer software and hardware) companies with respect to their international business operations and transactions, as well as investment banks, venture capital firms and other financial intermediaries that serve technology companies.

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Christopher A. Grew. This work reflects the law at the time of writing.