The industry term ‘liquidation preference’ is a legal clause denoting how a particular business willl be paid if a ‘liquidation event’ arises.
We’ll explain the term in detail below.
Liquidation Preference Definition
Liquidation preferences are legal clauses commonly included in business contracts where a particular party wishes to gain clarity over when they will be paid in the event of certain business situations. The preference means they will get paid first over other creditors.
A liquidation preferences clause effectively disrupts the normal order of priority when payments are made, placing the preference holder before other parties.
The Use of Liquidation Preferences in Venture Capital Deals
One of the typical areas where liquidation preferences are seen is when a hedge fund is investing in a promising start up. Including the liquidation preference within the contract gives them a high level of control over when and how they will get their money back, and thus reduces their perceived risk.
It’s important to state that in these situations the company need not actually become insolvent to trigger the preference: rather, a number of situations may be considered ‘liquidation events’. If the business is sold at a profit, has a public offering, or simply pays dividends, it may be classified as a liquidation event, and thus the venture capital firm receives its money before common stockholders, or even the owners of the firm.
There are three common forms of liquidation preference.
Non Participating – These grant the investing company the right to recoup either their original investment sum or a multiple thereof. Once this money has been paid out, the remaining funds are distributed to shareholders as usual, without further benefiting the investor. Business founders would typically consider this type the most beneficial to their own interests.
Full Participating – The investor recoups either their original investment or a multiple therefore, plus gets to participate in the remaining distribution with the shareholders. Investors tend to push for this as it gives them the strongest possible chance to make money.
Capped Participating – This version means the investor gets to recoup their original investment or a multiple therefore, plus a capped participation in the distribution of remaining proceeds. After the cap is reached, the funds remaining would be distributed as normal to the remaining shareholders.