How does a liquidation preference work?

The liquidation preference impacts the order of pay-outs in a liquidity event (waterfall) and can have significant effects on the distribution of proceeds. Preferred shareholders benefiting from this clause are typically investors who injected capital into the company.

Fixed Liquidation Preference:

Under a fixed liquidation preference, preferred shareholders receive a predetermined amount (typically 1x/1,5x/2x of the investment amounts) first before the remaining proceeds are distributed to other shareholders. For example, if an investor has invested EUR 2 million and has a fixed liquidation preference of 1x, it would receive the first EUR 2 million of the proceeds before the remaining proceeds are distributed among other shareholders.

So far so good. The more important question is if the liquidation preference is a non-participating or a participating one.

Example: An Investor has invested an amount of EUR 2 million in a startup against a participation of 10% of the non-diluted share capital. Later, all shares in the startup have been sold to a third party at a price of EUR 10 million.

1. Participating Liquidation Preference

   With a participating liquidation preference, preferred shareholders not only receive their original investment back but also a percentage of the remaining proceeds after the original investment has been repaid.

   For example, in a EUR 10 million exit an investor, who holds 10% of all shares in the startup with a participating preference of 1x and an investment of EUR 2 million would first receive back its EUR 2 million. Then the rest of the proceeds (= EUR 8 million) will be distributed between all shareholders pro rata to their participation in the startup. The investor would also receive an additional EUR 800,000 (= 10%) from the remaining proceeds.

   Result:

   Investor: EUR 2.8 million

   Founders: EUR 7.2 million
   
   

2. Non-Participating Liquidation Preference

A non-Participating Liquidation Preference means that the investor is entitled to receive whichever amount is higher between the 1x investment amount and their pro rata share of the remaining proceeds.

For example, in a EUR 10 million exit an investor, who holds 10% of all shares in the startup with a participating preference would receive the higher of:

1. 1x of the investment (= EUR 2 million) or
2. The amount which would be payable in case of a pro rata distribution based on the participation in the startup = EUR 1 million (= 10% of the exit proceeds).

Result:

Investor: EUR 2 million

Founders: EUR 8 million

It's important to note that the liquidation preference is a crucial negotiation point in investment agreements. For founders, it's essential to understand the implications of the liquidation preference on company valuation and proceeds distribution and ensure that the agreement is fair and balanced.