A liquidation preference gives a right to certain shareholders over the others to receive a greater proportion of the remaining value of the company should a liquidation event occur.
The meaning of a liquidation event should be defined within the shareholders agreement as well. It may be the sale of substantially all the assets, bankruptcy, or any other situation where shareholders are compelled to sell their equity, such as when a new investor dilutes proportional ownership by buying shares from all the others or subscribes to newly issued shares. A liquidation event might relate to the sale of a business division, and not just the whole business.
The reason for including a liquidation preference provision in a shareholders agreement is to reduce the risk of ownership (if the business is less successful than anticipated) or increase the rewards of ownership (if the business is successful and eventually sold) comparative to other owners. It is a tool that venture capital firms, business angels and other professional investors use both to protect their investment, and to give a superior return on a given level of capital investment. For the professional investor, it is usually one of the more important terms to negotiate (most likely as important as the price that will be paid) because it influences heavily both the downside and the upside risks.
How returns are decided
In addition to defining the liquidation event, a liquidation preference clause also must set out how the value should be apportioned. That might be based on a formula, or set percentages, or a formula for one shareholder and percentages for the remainder.
It might name the shareholders specifically, or refer to classes (if different classes of shares exist), or identify shareholders in some other way.
Returns can also be limited at levels, positively or negatively. As examples, all investors might be paid pro-rata to their shareholdings until a limit has been reached. After that, only preference holders are paid. Alternatively, the preference holder may be paid first to a limit, after which all the shareholders are paid. There may be several levels or caps, in order to distribute the value as required.
If an investor has the right to returns regardless of caps, he is said to fully participate. Otherwise, he is said to have capped participation.
Rights assigned to classes
Using a class of shares is neat way of assigning rights to a group of shares, which can be transferred between shareholders. Professional investors therefore usually insist that an equity investment is for shares in a new class. A right of liquidation preference then only applies to members in a specific class.
Stacked rights
If investors believe that there might be future rounds of financing (for example, because those future rounds would create liquidation events that would allow their investment to be returned to them faster than if the business were sold to a trade buyer), then the preference might give later investors greater rights to be repaid than earlier ones. This is usually acceptable to the earlier ones because they have been partially repaid when the later ones came in. Such rights are said to stack on top of each other at each financing round.
Dips
If the liquidation event is a conversion of one class of share to another, then shareholders might have the right to take what are known as secondary or tertiary “dips”. In layman’s terms, this is where they have a right to receive a preferred return on the first event, and retain the right for further returns on later liquidation events. Usually later rights are diluted, in that the proportion taken is less.
However, since secondary and tertiary dips reduce the size of the pot for other investors, if those rights exist, they can dissuade new investors from investing. So rights to multiple dips are usually given only when additional incentive is required for an investment to be made.
Summary
Liquidation preferences can be simple or complicated. They are a way of changing investment returns in proportion to share ownership when planning for exit. Unless the shareholders are investors who require a highly structured return profile (usually when a large investment has been made), the added complication of having one doesn’t justify the advantages.