A liquidation preference is a contractual provision that grants certain shareholders, usually investors, a preferential right to a portion of the proceeds in the event of liquidation or sale of the company. It serves to reduce the investors’ risk and secure their return by ensuring that these investors receive all or part of their invested capital back before the other shareholders receive a share of the proceeds.

Types of liquidation preferences

There are various types of liquidation preferences that can be agreed in financing agreements:
1. Simple liquidation preference (non-participating): The preferred investors first receive their investment amount back before the other shareholders participate in the proceeds. They then no longer participate in the distribution.
2. Multiple liquidation preference: Here, the preferential investors receive a multiple of their investment amount, e.g. twice the amount, before the other shareholders are taken into account.
3. Participating liquidation preference: The preferential investors first receive their investment amount and then additionally participate pro rata with the other shareholders in the distribution of the remaining proceeds.

Legal classification in Germany

In Germany, liquidation preferences are generally permissible, but are subject to the limits of company law. When structuring liquidation preferences, care must be taken to ensure that they do not violate mandatory legal provisions or common decency. They are often regulated in shareholders’ agreements or investment contracts and can be structured as preferential rights that are linked to certain share classes (e.g. preference shares).

Effects of the liquidation preference

Liquidation preferences can have a significant impact on a company’s capital structure. Founders and early employees of a startup can be disadvantaged in their participation in the exit proceeds by high liquidation preferences of investors. When negotiating such clauses, it is therefore important to find a balance that takes into account both the protection of investors and the interests of founders and employees. The liquidation preference can also influence the motivation of co-founders and employees, as they generally receive a smaller share of the payouts in the event of a sale or liquidation, depending on the amount of the agreed liquidation preference.

When negotiating investment agreements, the details of the liquidation preference in particular should be carefully defined, including the relevant ratios and terms. It is important that both founders and investors analyze the potential impact in different scenarios to understand how a liquidation event will affect their respective stakes.

Conclusion

Liquidation preferences are an essential tool in startup financing, as they serve to protect the interests of investors and encourage them to provide capital. However, they are also a double-edged sword that can affect both the founders and the employees in their participation in the success of the company. Therefore, all parties involved should think carefully about the design and risks of liquidation preferences in order to find a fair and acceptable solution.