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.

A priority on the exit proceeds

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.

How flexible are preferential liquidation clauses?

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.

FAQ

What is a preferential liquidation right?

A preferential liquidation clause is a protection mechanism granted to investors that allows them, in the event of an exit, to receive some or all of the exit proceeds in priority to the other shareholders.

It generally allows the investor to recover its investment first, potentially increased by an agreed return.

As a result, exit proceeds are not necessarily distributed in proportion to each shareholder’s ownership percentage. An investor benefiting from a liquidation preference may receive a larger share of the proceeds than its percentage of shares would otherwise imply.

What is an exit in a preferential liquidation clause?

“Exit” is a generic term covering events that directly or indirectly correspond to a sale or realization of the company or its value.

Depending on the drafting, this may include a change of control, the sale of all or substantially all of the company’s assets, an initial public offering (IPO), or the liquidation of the company.

An Exit is the event that triggers the application of the preferential liquidation clause.

Why do investors ask for a preferential liquidation right?

In an equity financing, professional investors often pay a significantly higher price per share than the founders and early investors paid when the company was created or at an earlier stage.

A preferential liquidation right allows them to protect part of that investment risk and limit the impact of this difference in entry price.

The clause is generally included in the shareholders’ agreement and the company’s bylaws.

When is a preferential liquidation right negotiated?

It is usually negotiated as part of the investment terms, alongside the company’s valuation and thus the subscription price paid by the investor.

The two discussions are closely connected, because the liquidation preference affects how the investor and the existing shareholders will share the proceeds if an exit occurs.

The principle and main terms of the liquidation preference therefore often already appear in the term sheet.

Is a preferential liquidation clause always unfavourable to founders?

Not necessarily.

There is considerable flexibility in how a liquidation preference can be structured, and its economic effect depends heavily on the drafting, for example, whether it is participating or non-participating and whether any multiple or return applies.

Founders and early investors should therefore look closely at the clause, as different structures can lead to very different outcomes depending on the value of the exit.