Liquidation preferences secure the right of investors to receive repayment of their investment before other shareholders in the event of a liquidity event. These preferences can take various forms, including multiples, participation rights, and seniority structures, providing both investors and founders with important incentives and protections.
I. What Are Liquidation Preferences or Liquidation Rights?
The term "liquidation preference" or "liquidation rights" refers to the financial preference rights of investors over the management team and founders. These rights ensure that preferred shareholders are entitled to a share of the liquidation proceeds (see Art. 656 para. 2 OR) or to a portion of the proceeds from the realization of the company's value, i.e., during a liquidity event.
The exact definition of a liquidity event depends on the contractual agreement. Typically, it refers not only to "negative" events such as bankruptcy or liquidation but also to "positive" ones like mergers, the acquisition of company shares, the sale of significant assets, or changes in ownership structure. What defines a liquidity event is the realization of part or all of the company’s value, resulting in cash proceeds.
II. How Can Liquidation Preferences Be Structured?
Contractual provisions regarding liquidation preferences usually contain the following four elements. Naturally, preferences can vary and include additional features depending on the case.
1) Initial Liquidation Preference (Multiples)
The multiple, or initial liquidation preference, defines the percentage of the investment that must be returned to the investor before common shareholders, such as founders or management, participate in the liquidity event.
- A 1x multiple means that an investor who has invested CHF 3 million will receive the entire CHF 3 million back before other shareholders participate in the proceeds. If the company is sold for CHF 15 million, the investor is guaranteed CHF 3 million, regardless of their equity stake. If the company is sold for only CHF 1 million, the investor receives the entire amount, and the common shareholders receive nothing.
- A 2x multiple means the investor in the same scenario must receive at least CHF 6 million before any remaining proceeds are distributed to other shareholders.
In practice, multiples are usually between 1x and 2x, but they may be higher depending on market conditions and risk allocation.
2) Participation Rights ("Participating" vs. "Non-Participating")
In addition to the multiple, it is crucial to determine whether preferred shareholders participate in the proceeds beyond their liquidation preference.
a) Non-Participating Liquidation Preference
With a non-participating liquidation preference, the investor can either exercise the liquidation preference or convert their preferred shares into common shares to participate like other shareholders.
Example:
An investor puts CHF 1 million into a start-up for 20% equity and secures a 1x non-participating liquidation preference. The company is sold for CHF 2 million. The investor can:
- Exercise the liquidation preference and receive CHF 1 million.
- Convert their shares into common stock, receiving CHF 400,000 (20% of CHF 2 million).
In this scenario, the investor will exercise the liquidation preference to receive CHF 1 million.
If the company is sold for CHF 6 million:
- Exercising the liquidation preference yields CHF 1 million.
- Converting the shares yields CHF 1.2 million (20% of CHF 6 million).
The investor will opt for conversion since it offers a higher return.
The conversion threshold marks the sale price at which the two options yield the same outcome. If the company sells for CHF 5 million, the investor will receive CHF 1 million either way. Below this threshold, the investor exercises the preference; above it, they convert to common shares.
b) Participating Liquidation Preference
With a participating liquidation preference, the investor receives both the initial multiple and a share of the remaining proceeds according to their equity stake, without converting their preferred shares.
Example:
An investor with 20% equity and a 1x participating liquidation preference invests CHF 1 million. If the company is sold for CHF 2 million, the investor receives:
- CHF 1 million (investment return) + CHF 200,000 (20% of the remaining CHF 1 million).
The total payout is CHF 1.2 million. This dual benefit is called double-dipping, making conversion to common shares less attractive unless a cap is in place.
3) Cap on Participating Preferences
Participating liquidation preferences can disadvantage founders and existing shareholders by allowing investors to participate without limits. To prevent this, a cap limits the total payout to participating preferred investors.
The cap introduces a conversion threshold, meaning even investors with participating preferences may convert their shares if their equity-based payout exceeds the capped amount.
4) Seniority Structures
When a company raises capital through multiple financing rounds, the priority among investors in the event of a liquidity event must be defined through seniority structures. These structures determine the exit waterfall—how proceeds are distributed among preferred shareholders.
a) Standard Seniority
Under standard seniority, investors from the latest round are paid first, followed by earlier investors. For example, Series B investors receive their full liquidation preference before Series A investors.
Example:
A company raises CHF 1 million in Series A and Series B rounds, each with a 1x liquidation preference. If the company is sold for CHF 900,000, Series B investors receive the entire amount, and Series A investors receive nothing.
b) Pari Passu Structure
In a pari passu structure, all preferred shareholders have equal priority. If the proceeds are insufficient to satisfy all preferences, they are distributed pro-rata based on the investment amount.
Example:
If a company raises CHF 77 million across multiple rounds, with 51.9% coming from Series C investors, and sells for CHF 50 million, each investor receives a share of the proceeds proportional to their investment. This structure is often used by companies with strong negotiating power and access to capital.
c) Tiered Seniority
Sometimes, investors are grouped into tiers. For instance, Series E and D investors may share the highest tier, while Series C and B investors share the middle tier, and Series A investors occupy the lowest tier. Within each tier, proceeds are distributed pari passu.
III. Why Are Liquidation Preferences Important?
Liquidation preferences provide investors with security, ensuring they recover their invested capital even if the company sells for less than its valuation. Consequently, investors are advised to negotiate appropriate liquidation preferences in their agreements.
However, liquidation preferences can also affect the motivation of founders and management. The more extensive the preferences, the smaller the potential payout for the founding team, which may reduce their motivation.
A savvy investor must therefore strike a balance between optimal investment terms and maximizing the motivation of the founders and management team. The final outcome depends on the company’s stage, the negotiating power of the parties, and the existing capital structure.
