A liquidation preference clause is usually incorporated into a shareholders agreement by a professional investor (such as a business angel or venture capital firm) as a risk reduction tool in case the business fails but still has value in it, or to give particular shareholders a superior return over others on a profitable sale. For the investor, it is usually one of the most important terms to negotiate because it largely defines the outcome of investment.
The preference term sets out how the remaining value of the company is shared between the equity owners when a liquidation event occurs. That could be a negative event such as bankruptcy, but it could also be any other time where shareholders receive money for giving up equity, such as on acquisition by another company. Some shareholder agreements also define a liquidity event as the sale of “substantially all the assets”.
The preference clause should cover two pieces of information: who receives the right to a greater return, and what that return is.
Professional investors usually buy a particular issue of equity, such as “Preferred Series A” because doing so allows rights to be tied neatly to that stock. As a result, “who” receives the right to a preference is commonly defined by reference to share classes. However, there is no specific need to do this – you could refer to a specific investor by name.
The return might be a straightforward multiple of the share price paid (such as one and a half times the price) before the other shareholders are paid, or it may be on a pro-rata basis with other share class owners until a cap has been reached. The first is known as full participation, and the latter is known as capped participation. Non-participating describes those shareholders who do not hold the right at all. Capped participation favours the founders more than full participation because as “other shareholders”, the founders benefit at the same time as the investor, and not just once the investor has had his return goals met.
There can be added complications if there are multiple institutional investors and multiple financing rounds. Preference can be stacked on top of each other, so that later investors have rights to be repaid before earlier ones. How this is done is largely a matter of negotiation between investors.
If the liquidation event is a conversion of one type of share class to another, then investors might have secondary or tertiary “dips” at returns. They might have the right to receive a multiple of price paid at the first conversion, and a secondary right to receive another multiple when the new shares they acquire are later sold or converted.
Liquidation preference clauses are usually only used by professional investors. So as a founder looking to put in place a shareholders agreement with other founders, this isn’t a clause that we would say that you need to have. However, it is useful to understand how one works.