Participating or non-participating preferential liquidation right

An investor that the company cannot do without requires a preferential liquidation right. If the existing shareholders cannot get him to waive the this request, they can still potentially nullify its effect.

There are in fact two main categories of preferential liquidation rights: ‘non-participating’ and ‘participating’.

What is the difference between these two versions?

• Non-participating preferential liquidation right
  
  In the case of a non-participating preferential liquidation right, part of the exit proceeds is allocated in priority to the investors benefiting from the preferential liquidation right, and therefore in priority to the other shareholders. This amount generally corresponds to their investment, subject to the potential application of a guaranteed minimum return on investment.
  
  The remainder of the proceeds of the exit is then distributed among the other shareholders. Investors benefiting from preferential liquidation do not participate in the distribution of the remaining exit proceeds.
  
  However, it is often provided that investors benefiting from the preferential liquidation right may waive the benefit of their preferential liquidation right in favour of an ordinary distribution proportionate to their share participation, which may be more advantageous for them if the exit proceeds are sufficiently high.

• Participating preferential liquidation right
  
  In the case of a participating preferential liquidation right, the principles remain the same with one important exception: investors benefiting from the preferential liquidation also participate in the distribution of the balance of the exit proceeds.
   
  A participating preferential liquidation right is therefore always more favourable to investors than a non-participating preferential liquidation right.
   
  In order to mitigate the effect of a participating preferential liquidation clause, it is possible to provide for it to be capped, i.e. investors participate pro rata in the distribution of the balance of the exit proceeds, but only up to a certain maximum. Finally, other arrangements are possible.

The founder’s first negotiating objective in relation to the preferential liquidation right will therefore be to get the investor to accept a ‘non-participating’ rather than a ‘participating’ one.

But how does this translate into figures?

The financial impact of a liquidation preference can vary significantly depending on the type of clause (participating or non-participating), the investment amount and the exit valuation. What may appear as a small contractual detail can materially change how the exit proceeds are distributed between founders and investors.

To better understand these mechanisms, you can test different scenarios using our liquidation preference simulators, which allow you to visualize how the exit proceeds would be allocated depending on the structure of the clause and the exit valuation.