Hope you're having a good day! We’re here to sprinkle some legal knowledge on it. Today, we’re diving into liquidation preference. Sounds complicated? Don’t worry, we’ll make sure you get the gist of it.
What’s a liquidation preference?
Liquidation preference tells you how much and in what order investors and other shareholders get paid on exit. Investors use liquidation preference to protect themselves from the downside. There are two dimensions you need to know about:
1. Liquidation multiple
Multiple liquidation preference means that the investor gets their original investment times the agreed multiple before other shareholders get paid. Multiples are usually around 1x- 2x but can be higher based on market conditions. To illustrate, if a company has one investor who invests € 5M with 2x multiple liquidation preference and the company later sells for € 20M, the investor gets at least € 10M.
2. Participating vs non-participating preference
Participating liquidation preference
Here, investors get their initial investment back, and then get a second slice based on their company ownership. For example, if a company has one investor who put in € 5M for a 20% share and the company sells for € 20M, they’d walk away with at least € 8M.
Non-participating liquidation preference
Here, the investor should receive the higher of the original investment amount or their pro rata share of the remaining company shares. The same investor who brought in € 5M and holds 20% of all shares would receive the higher of their original investment or the amount of a pro rata distribution based on their stake in the company.
Why does this matter?
Liquidation preference tells you how much investors get on exit. It’s important for founders, investors and employees because it tells you how profit gets distributed.
Dos and don’ts
Navigating the waters of liquidation preference can be tricky, but we've got some simple tips to help you.
In a nutshell
Every company aims for an exit. And once you get there, liquidation preference will be the central point for all payout discussions. It’s important for every stakeholder in the company; the founders, the investors and the employees.
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