Liquidation preference

What it means

A liquidation preference is a term between an investor and the founders that sets the order and amounts in which money is distributed on a so-called liquidation event. That means not only winding up the company but above all its sale, merger or other exit. An investor with a preference gets paid before the other shareholders.

The most common is a 1x preference: the investor first gets back what it invested and the rest is shared out. With a non-participating preference the investor chooses between getting its investment back and its percentage share; with a participating preference it gets both, the investment and a share of the rest, which is far less favourable to founders.

The preference protects the investor in a weaker scenario where the company sells for less than expected. In a successful sale at a high price it matters less. It is a standard part of venture capital investments and appears in every term sheet.

How it works in practice

In negotiations we advise founders to insist on a 1x non-participating preference, which is the market standard. Multiples of 2x or 3x and participation are a sign that the investor sees the risk as high or that the founders’ bargaining position is weak.

Before signing it is worth modelling on the cap table how much the founders and employees with options would receive at various sale prices. With several funding rounds, preferences stack up, and at a lower price very little may be left for the founders.

In a Slovak s. r. o. a preference is implemented mainly through a shareholders’ agreement and the articles, for instance using different classes of shares with different rights. In a joint-stock company, preference shares are used. We assess the tax consequences of distributing the proceeds according to the specific deal structure.

What to watch out for

The most common mistake is focusing only on valuation in negotiations and overlooking the preference. A higher valuation with a 2x participating preference can be worse for founders than a lower valuation with a standard 1x preference.

The second risk is the interplay with anti-dilution protection and later rounds. If the company raises money at a lower valuation, investors get more shares and their preferences add up. In a moderately successful sale, founders and employees may receive almost nothing, which undermines their motivation to carry on.