Legal

A Founder’s Guide To Understanding Liquidation Preference

Liquidation is the process of closing a business and distributing its assets among stakeholders, creditors, and rightful claimants. In the event of a corporate liquidation, preferred shareholders recover their investments first, prior to all other shareholders, in the process known as Liquidation Preference. Liquidation preference is a form of protection for investors as it guarantees them a certain minimum payment, regardless of the company’s valuation at exit. Investors can choose between non-participating and participating liquidation preference.

   

Non-participating liquidation preference allows investors to receive predetermined returns without any share in the surplus. In contrast, participating liquidation preference allows investors to receive predetermined returns as well as a share of the surplus proceeds based on their shareholding.

   

Standard Seniority Liquidation Preference is followed by most early-stage companies, where liquidation preferences are honored in reverse order from the latest investment round to the earliest. Pari-Passu Seniority gives all preferred investors equal seniority status, meaning that all investors would share in at least some part of the proceeds. Tiered Seniority is a hybrid between standard and pari-passu seniority, with investors grouped into distinct seniority levels.

 

Investors ask for liquidation preference to protect themselves, particularly if a company fails to meet expectations and sells or liquidates at a lower valuation than anticipated. Liquidation preferences are expressed as a multiple of the initial investment and are most commonly set at 1X. In the event of liquidation, investors receive the full amount of their investment before any other equity holders or their share in the liquidation proceeds on a pro-rata basis, whichever is more. Understanding liquidation preference is important for founders to negotiate well with potential investors.

   


Disclaimer: This article has been prepared for general guidance and information as a guide to understanding the concept of liquidation preference from a founder’s perspective and does not constitute professional advice or a legal opinion and are the personal views of the author. The matters described herein are general in nature and have not been evaluated based on applicable laws. This article is based on information available in the public domain and has not been verified for its accuracy. You should not act upon the information contained in this note without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this note. Treelife and its employees accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Without prior permission of the author / Treelife this note may not be quoted in whole or in part or otherwise referred to any person or in any documents.

Last Updated on: 8th December 2023, 01:34 pm


Disclaimer:

The content of this article is for information purpose only and does not constitute advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer to relevant provisions of statute, latest judicial pronouncements, circulars, clarifications etc. before acting on the basis of the above write up. The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that the Author / Treelife is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof.

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