What is a preferential liquidation right?

You are a start-up and you receive a term sheet from an investor for a possible equity investment in your company. This term sheet provides for a preferential liquidation right in favour of the investor.

But what is a preferential liquidation right?

A preferential liquidation clause is a protection mechanism granted to investors which enables them, in the event of an exit (*), to receive some or all of the proceeds of the exit in priority.

(*) 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.

The preferential liquidation clause therefore allows investors to recover their investment in priority to other shareholders, possibly increased by a certain return on investment.

The distribution of exit proceeds will not necessarily be proportional to the distribution of shares among shareholders: investors benefiting from preferential liquidation may receive a share of exit proceeds greater than the proportion of shares they hold in the company.

It is therefore essential to pay particular attention to this clause whether you are a founder or a first-time investor, as the preferential liquidation granted to a new investor may adversely affect your own return on investment and its effects may vary depending on its terms.

How can investors justify such unequal treatment in their favour?

When a company is the subject of equity financing, the price per share paid by professional investors, such as venture capitalists or business angels, is generally much higher than that paid by the founders and initial investors.

To adjust their risk and limit the effects of this difference, professional investors may require the inclusion of a preferential liquidation clause at the time of their investment. This clause is generally included in the shareholders’ agreement and/or the company’s bylaws.

The introduction of a preferential liquidation clause therefore naturally occurs at the same time as discussions on the valuation of the shares at the time of investment.

However, there is considerable freedom in the way the clause is structured, which means that these clauses can be adapted to benefit founders, investors, or a mixture of the two, depending on the proceeds of the exit.