In venture capital investment agreements between founders and investors, so-called liquidation preferences are an absolute must-have from the investor's perspective. Without them, an investor can incur significant losses in weak but also moderate exit proceeds. On the other hand, overly extensive liquidation preferences can result in founders receiving disproportionately little or even no money in the case of quite good exit proceeds. As a firm that advises both founders and investors on corporate law matters, we would like to provide you here with a comprehensible insight into the not entirely straightforward subject: What are liquidation preferences? What different types of liquidation preferences are there? And what must be considered in contract drafting so that the legitimate interests of both parties reach a reasonable balance?
As mentioned at the outset, liquidation preferences generally find their way into the investment agreement (often called a "shareholders' agreement") between the founders of a company and an investor. The scenario is usually as follows: for financing purposes, the original shareholders (founders) bring a financially strong partner on board, who also becomes a shareholder by means of the shareholders' agreement. In addition to the articles of association, which for capital companies (e.g. GmbH, AG) is also called the articles of incorporation, published in the commercial register and therefore publicly accessible, a further (confidential) agreement is concluded in the form of the investment agreement, which governs the details of the investment and the cooperation. In addition to guarantees in the investment agreement, the investor will typically also insist on the inclusion of a liquidation preference provision, which protects them against the risks of their investment.
Case example illustrating the need for liquidation preferences
Let us illustrate the corporate relationships between the parties and their financial implications with an example: the two founders G1 and G2 are shareholders of a GmbH, each holding 20,000 shares at one euro each. The company is on a growth trajectory and requires fresh capital, which neither G1 nor G2 has, which is why investor I is admitted to the company. I invests €1 million. Of this, €990,000 flows into the company's capital reserve. At the same time, the GmbH's share capital is increased by €10,000 (I's shares) to €50,000. I is therefore now a 1/5 (20%) shareholder in the GmbH, with G1 and G2 each holding 2/5 (40%). Since the value of the company is by no means measured by its share capital, I has not yet made a bad deal. The value of the company may already be many times higher at this point, with the non-monetary contributions of the original shareholders – i.e. what G1 and G2 have put into the founding and development of the company in terms of ideas and commitment (business idea, customer base, etc.) – to be appropriately taken into account. It is therefore quite common for the investor – depending on the estimated company value and the amount of their investment – to receive only a minority stake.
Nevertheless, I obviously bears the main burden of company financing and therefore also the predominant share of the financial risk. If the company were now to be sold, say at a sale price of €2 million, and there were no relevant agreement in the investment agreement, the sale proceeds would be distributed among the shareholders in accordance with the shares held by each. G1 and G2 would therefore each receive 40% of the proceeds (€800,000), while I would receive only 20% (€400,000). In this case, one would have to say that I made quite a bad deal, especially since I had invested €1 million in the company. The portion of the sale proceeds attributable to I neither covers the investment, nor was I able to realise a return.
What are liquidation preferences?
To prevent such a scenario, which understandably does not correspond to the investor's interests, liquidation preferences are standardly agreed upon in investment agreements. The term is conceptually somewhat confusing in that it refers to the generally rather undesired case of the dissolution (liquidation) of a company. What is meant, however, is the outcome more hoped for by founders and investors – that of a profitable sale of the company (exit). "Preferences" means that proceeds or surpluses should benefit a specific party, namely the investor, on a priority basis before taking into account shareholding ratios. In practice, a distinction can be made between participating and non-participating liquidation preferences. Return guarantees can also be regulated through liquidation preferences.
Non-creditworthy and creditworthy liquidation preferences
In our example, one can understand that I wants to be secured at least in the amount of the investment. A liquidation preference in the investment agreement between I and G1 and G2 could therefore be structured such that, upon a sale of the company, I receives the original investment of €1 million on a priority basis before the remaining proceeds are distributed among the shareholders in accordance with the shares held. Without further provisions, I would receive €1 million in the aforementioned example, which would be credited against the share actually due to I according to the shareholding ratio. For I, it therefore remains at €1 million, and the founders would split the remainder, each receiving €500,000. The liquidation preference thus has the consequence that the investor's financial contributions are given greater arithmetic weight compared to the founders' non-monetary contributions in the event of an exit or liquidation.
In the example just calculated, we encountered a non-participating or creditworthy (non-participating) liquidation preference. The proceeds preferentially distributed to I are credited against the total proceeds distribution. However, I would then have achieved no return whatsoever, and depending on the effort involved and the time elapsed, the founders, who can still control the company with a majority, can quickly and profitably benefit. In view of the generally strong negotiating position of the investor in structuring the investment agreement, creditworthy liquidation preferences are therefore the exception in practice. The investor will usually insist on a participating or non-creditworthy (participating) liquidation preference (participating liquidation preference).
A liquidation preference in the investment agreement between I and G1 and G2 would accordingly be structured such that, upon a sale of the company, I receives the original investment of €1 million on a priority basis and only the remaining proceeds are distributed among the shareholders – again with investor participation – in accordance with the shareholding ratio. The distribution of the sale proceeds would therefore change such that I would first receive the investment of €1 million and subsequently 20% of the remaining €1 million in accordance with the shareholding. I would therefore receive a total of €1.2 million, while G1 and G2 would have to share the remainder, i.e. each receiving €400,000. This outcome seems entirely appropriate given I's considerable investment and the associated risk. The so-called participating liquidation preference is therefore also the norm in practice.
Liquidation preferences and return
In addition, the investor will often want to have a certain minimum return secured, since they did not invest in the company out of pure philanthropy. Preferentially distributed to the investor would then not only be the investment but also a defined return, all usually in the form of a participating liquidation preference. Let us say the investor has a guaranteed annual return of 30% structured in this way and an exit as described above occurs after three years. Then I receives, as above, first €1 million investment, then €900,000 (3 years x 30% of €1 million) and on the remaining €100,000 a further 20%. The founders would then receive only €40,000 each, which is no longer appropriate for an effort of over 3 years. After four years, they would receive nothing at all. Founders should therefore carefully calculate return guarantee clauses to prevent the exit – which is often worked towards – from barely bringing any financial joy.
Restrictions on liquidation preferences
The last example shows that liquidation preferences can result in proceeds distribution being disproportionate to the investor's original investment and risk and can significantly disadvantage founders. Restrictions on liquidation preferences are quite common and are intended to prevent the investor from being unreasonably favoured in proceeds distribution ("double dipping"). This applies particularly to cases of high exit proceeds. For example, it can be agreed that the investor's participation in the pro-rata distribution by shareholding shall cease entirely from a certain sale proceeds amount. This could, for example, be structured such that I participates in the second stage of proceeds distribution by shareholding only up to exit proceeds of €5 million, or that the preference amount from the first distribution stage (return of the invested €1 million + return) is deducted at the second stage of proceeds distribution by shareholding. By making forward-looking agreements in the investment agreement on this point, potentially staggered according to the level of exit proceeds, it can be ensured that both the investor's financial interests (securing the investment, return) and the founders' interests (recognition of their non-monetary contributions to company success) are taken into account in the distribution of the exit proceeds.
Liquidation preferences in conjunction with drag-along clauses
In addition to liquidation preferences, so-called drag-along clauses are also standardly found in investment agreements because they protect the interests of the investor with the stronger negotiating position. These clauses have certain effects in conjunction with liquidation preferences that must be taken into account in contract drafting. Drag-along clauses have the effect that a shareholder with a majority stake who wishes to sell their shares can require the other shareholders to sell their shares as well – proportionately at the same terms. If in our example the shareholding structure were such that I held a majority of the GmbH's shares, and had included a drag-along clause in their favour in the investment agreement, I could unilaterally force a sale of the company, in which G1 and G2 would also be compelled to sell their shares. If the proceeds of the exit forced by I and borne by G1 and G2 as well do not exceed the investment preferentially secured by I by way of liquidation preference plus the return, the consequence is that G1 and G2 receive nothing at all despite their shareholdings, since all exit proceeds flow to I as a result of the liquidation preference. I could therefore, if they want to deploy the investment elsewhere in the short term or the guaranteed and currently achievable minimum return is already sufficient, force an exit at any time, including at times that are rather unfavourable for the founders. In order to safeguard the founders' interests, an investment agreement that provides for both a liquidation preference and a drag-along clause in favour of the investor should relate these two provisions to each other, for example by providing that the minority shareholders' obligation to sell only arises from a certain level of exit proceeds.
Summary: liquidation preferences
It remains to be noted that liquidation preferences are a virtually indispensable instrument for investors to secure investments and return expectations in risky investments. At the same time, there are also ways and means available to founders in a structurally weaker negotiating position to structure liquidation preferences contractually such that no unreasonable disadvantages arise for them. However, as the example of the interactions between liquidation preferences and drag-along rights may have shown, considerable thought must go into this and various exit scenarios must be calculated in advance of contract negotiations.
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