How do you negotiate a preferential liquidation clause?

An investor makes his investment conditional on the introduction of a preferential liquidation clause. The existing shareholders don’t want it, but the investor won’t budge. Don’t panic! This is a classic requirement of professional investors!

If you can’t get the investor to waive the clause, you can still ask for its content to be amended.

Understanding preferential liquidation clauses

Preferential liquidation clauses organises a waterfall system to distribute the proceeds of an exit (*) among the various shareholders, potentially disproportional to the distribution of shares.

(*) an exit is a generic term used to describe any situation corresponding directly or indirectly to a sale of the company('s shares), i.e. a change of control, the sale of all or almost all of the company's assets, an initial public offering (IPO) or the liquidation of the company.

In the context of a preferential liquidation clause, the term ‘waterfall’ is a metaphor used to describe the sequence in which the proceeds of the exit are distributed among the shareholders. In a normal waterfall, the water flows from the top to the bottom, tumbling down different levels. In a financial ‘waterfall’, the money follows a similar path, step by step, in a predefined order. The proceeds of the exit are thus allocated in priority to certain shareholders over others.

This system of preferential liquidation is essentially a matter of contractual freedom for the parties concerned, subject to the application of mandatory legal provisions, such as the ban on unfair terms, and taking into account any tax implications.

Key elements to negotiate

When implementing a preferential liquidation right, various elements are often discussed in order to mitigate (or, on the contrary, enhance) the advantage it confers on investors and improve (or not) the position of existing shareholders.

In particular, the founder and the historical shareholders will negotiate the non-participating (vs. participating) nature of the preferential liquidation right.

Moderating factors in your favor

In addition, the founder and the historical shareholders may also try to use the following moderating levers:

• the distribution of a limited part of the proceeds of the exit to all shareholders before the application of any preferential liquidation right, which makes it possible to offer a minimum return on investment to the least favoured shareholders in the waterfall system and thus for investors to ensure their full cooperation at the time of the exit,

• an exception (‘carve-out’) in the waterfall for the management team or key employees compared with other historical shareholders,

• a disproportionate allocation of exit proceeds to founders after the application of investor liquidation preference right when exit proceeds exceed a specified threshold.

Factors that worsen your position

On the other hand, certain elements can worsen the situation of the founders and historical shareholders, such as the application of a multiple or a minimum return on investment formula to the amount of the investment protected by the preferential liquidation right.

Long-term implications and shareholder alignment

Although the preferential liquidation clause can serve as a powerful incentive at the time of an investment, in the long term it can create or increase a misalignment of interests between shareholders when it comes to agreeing on an exit process, particularly if certain exit thresholds modify the waterfall, which could reduce the founders’ motivation to reach the threshold before an exit or vice versa.

Because the financial consequences of a liquidation preference depend on several variables (investment amount, exit valuation, participating or non-participating structure, potential multiples or caps) the real impact of the clause is not always easy to anticipate.To better understand these mechanisms, you can test different scenarios using our liquidation preference simulators.

FAQ

What is the waterfall in a preferential liquidation clause?

The waterfall is the metaphor used to describe the order in which the exit proceeds are distributed among shareholders. Like water cascading from a waterfall, exit proceeds flow sequentially from top to bottom, filling each tier completely before spilling over to the next level. As a result, owning 20% of the shares does not necessarily mean receiving 20% of the exit proceeds.

Is a preferential liquidation clause freely negotiable?

Yes, the parties have broad freedom to negotiate how the preference works. In practice, tax considerations are more likely to influence the chosen structure than mandatory legal restrictions, which generally come into play only where the terms create an extreme imbalance between the parties.

What terms can founders negotiate to soften a liquidation preference?

Beyond the non-participating nature of the clause, three moderating levers are often negotiated: (i) the distribution of a limited part of the exit proceeds to all shareholders before any preferential right applies, (ii) a carve-out in the waterfall for (certain shares of) the management team, or (iii) changing the structure of the waterfall depending on the exit value, with more favourable terms for founders above specified thresholds. Extra care is required when setting these thresholds, otherwise a small increase or decrease in the exit proceeds can have a big impact on how those proceeds are distributed.

What terms can make a liquidation preference less favourable to founders?

The application of a multiple, or of a minimum return on investment formula, to the amount of the investment protected by the clause. These mechanisms increase the share taken in priority by the investors and reduce accordingly what is left to distribute to the other shareholders.

What long-term effect can a preferential liquidation right have on shareholder alignment?

A powerful incentive at the time of the investment, the clause can in the long run create or increase a misalignment of interests between shareholders when it comes to agreeing on an exit process. Where the waterfall changes at a specified threshold, founders may have a stronger or weaker incentive to pursue a higher exit price, depending on how much of the additional proceeds they would receive.