Liquidation preferences

Liquidation preferences in investment agreements

An article from Tobias Bystry

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 the event of poor or even moderate exit proceeds. On the other hand, excessively far-reaching liquidation preferences can result in founders receiving disproportionately little or no money at all from quite good exit proceeds. As a law firm that supports both founders and investors in corporate law issues, we would like to give you a clear insight into this not entirely uncomplicated matter: What are liquidation preferences? What are the different types of liquidation preferences? And what needs to be considered when drafting contracts to ensure that the legitimate interests of both sides are reasonably balanced?

As mentioned at the beginning, liquidation preferences are typically included in the investment 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 through the shareholders' agreement. In addition to the shareholders' agreement, which in the case of corporations (e.g. GmbH, AG) is published in the commercial register and can therefore be viewed by everyone, another (confidential) contract is concluded with the investment agreement, which regulates the details of the investment and the cooperation. In addition to guarantees in the investment agreement, the investor will usually also insist on the inclusion of a liquidation preference clause that protects him against the risks of his investment.

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Case study on the necessity of liquidation preferences

Let us illustrate the corporate relationships between the parties involved and their financial implications with an example: The two founders G1 and G2 are shareholders of a German GmbH, each holding 20,000 shares worth one euro each. The company is growing and requires fresh capital, which neither G1 nor G2 have, which is why investor Z joins the company. Z invests 1 million euros. Of this, 990,000 euros flow into the company's capital reserves. At the same time, the share capital of the GmbH is increased by 10,000 euros (shares held by Z) to 50,000 euros. Z therefore now holds 1/5 (20%) of the GmbH, while G1 and G2 each hold 2/5 (40%). Since the value of the company is not solely determined by its share capital, Z has not made a bad deal. The value of the company may already be significantly higher, considering the non-monetary contributions of the original shareholders, i.e. the ideas and commitment that G1 and G2 put into founding and building up the company (business idea, customer base, etc.), must be appropriately taken into account. It is therefore quite common for the investor to receive only a minority stake, depending on the estimated value of the company and the amount of his investment.

Nevertheless, Z naturally bears the main burden of financing the company and therefore also the majority of the financial risk. If the company were now sold, let's say at a sale price of 2 million euros, and there were no relevant provisions in the investment agreement, the proceeds of the sale would be distributed to the shareholders according to their respective shareholdings. G1 and G2 would therefore each receive 40% of the proceeds (800,000 euros), while Z would only receive 20% (400,000 euros). In this case, one would have to say that Z made a pretty bad deal, especially since he had invested 1 million euros in the company. Neither did the share of the sales proceeds attributable to him cover his investment, nor was he able to realize a return.

What are liquidation preferences?

In order to prevent such a scenario that is understandably not in the interests of the investor, liquidation preferences are typically included in investment agreements. The term can be somewhat confusing as it refers to the rather undesirable case of the dissolution (liquidation) of a company. What is meant, however, is the outcome of a profitable sale of the company (exit), which founders and investors tend to hope for. "Preferences" means that proceeds or surpluses are primarily allocated to a certain party, namely the investor, before taking the ownership stakes into account. In practice, a distinction can be made between participating and non-participating liquidation preferences. In addition, return guarantees can also be regulated via liquidation preferences.

Participating and non-participating liquidation preferences

In our example, it is understandable that I would like to be protected at least to the amount of his investment. One Liquidation preference in the participation agreement between I and G1 and G2 could therefore be structured in such a way that, in the event of a sale of the company, I would primarily receive his original investment of EUR 1 million before the remaining proceeds are distributed among the shareholders in accordance with the shares. Without further regulations, I would receive EUR 1 million in the above example, which would be offset against the share to which he is actually entitled according to the shareholding structure. I would therefore receive EUR 1 million and the founders would share the remainder and each receive EUR 500,000. The liquidation preference therefore means that the financial contributions of the investor are weighted more heavily than the non-monetary contributions of the founders in the event of an exit or liquidation.

In the example just calculated, we are dealing with a non-participating liquidation preference. The preferred proceeds distributed to Z are counted towards the total distribution of proceeds. However, Z would then have achieved no return at all and, depending on the investment and timing, the founders, who can still control the majority of the company, could quickly realize substantial profits. Given the investor's usually strong negotiating position when drafting the investment agreement, non-participating liquidation preferences are therefore the exception in practice. The investor will usually insist on a participating liquidation preference.

A liquidation preference in the investment agreement between I and G1 and G2 would therefore be structured in such a way that I would primarily receive his original investment of EUR 1 million in the event of a sale of the company and only the remaining proceeds would be distributed among the shareholders in accordance with the shares - again with the participation of the investor. The distribution of the sales proceeds would therefore change in such a way that I would first receive his investment of EUR 1 million and then 20% of the remaining EUR 1 million in accordance with his shares. I would therefore receive a total of EUR 1.2 million, while G1 and G2 would have to share the remainder, i.e. each would receive EUR 400,000. In view of I's considerable investment and the associated risk, this result appears to be in line with the interests of the parties. The so-called participating liquidation preference is therefore also the rule in practice.

Liquidation preferences and return

In addition, the investor will often want to secure a certain minimum return, as he has not invested in the company out of pure philanthropy. The investor would then prefer to receive not only his investment, but also a specific return, usually structured as a participating liquidation preference. Let's say the investor is guaranteed an annual return of 30% in this manner, and the above-mentioned exit occurs after three years. Then, as decriped above, Z would first receive an investment of 1 million euros, then 900,000 euros (3 years x 30% of 1 million euros) and further 20% on the remaining 100,000 euros. The founders would then receive only 40,000 euros each, which may no longer appropriate for an investment of over 3 years. After four years, they might even receive nothing. Founders should therefore carefully calculate clauses regarding return guarantees to prevent the exit - which is often the goal - from being financially unpleasant.

Restrictions on liquidation preference

The latter example shows that liquidation preferences can result in the distribution of proceeds becoming disproportionate to the investor's original investment and risk, which can put the founders at a considerable disadvantage. Restrictions on liquidation preference are quite common and aim to prevent inappropriate preferential treatment of the investor in the distribution of proceeds ("double dipping"). This applies in particular to cases of high exit proceeds. For example, it can be agreed that the investor's participation in the pro rata distribution according to shares ceases completely above a certain level of sales proceeds. This could be structured in such a way that Z only participates in the second stage of the distribution of proceeds based on shares up to exit proceeds of 5 million euros, or that his preferential amount from the first distribution stage (return of the 1 million invested + return) is deducted in the second stage of the distribution of proceeds based on shares. By proactively negotiating such conditions in the investment agreement, which may be staggered according to the amount of the exit proceeds, it can be ensured that both the financial interests of the investor (protection of his investment, return) and the interests of the founders (appreciation of their non-monetary contributions to the company's success) are taken into account in the distribution of the exit proceeds.

Liquidation preferences in combination with drag-along clauses

In addition to liquidation preferences, so-called drag-along clauses are also typically found in investment agreements, as they protect the interests of the investor with strong negotiating power. In conjunction with the liquidation preferences, these clauses have certain effects that need to be taken into account when drafting contracts. Drag-along clauses allow a majority shareholder who wishes to sell his shares can demand that the other shareholders also sell their shares - on a pro rata basis at the same conditions. If, in our example, the shareholding structure were such that Z held a majority of the shares of the GmbH and had included a drag-along clause in the investment agreement in his favor, he could single-handedly push through a sale of the company, forcing G1 and G2 to sell their shares as well. If the proceeds from the exit forced by I and borne by G1 and G2 are not higher than the investment secured by Z via the liquidation preference plus its return, this would mean that G1 and G2 would be left completely empty-handed despite their shareholdings, as the entire exit proceeds would flow to Z as a result of the liquidation preference. Z could therefore force an exit at any time, even at times that are rather unfavorable for the founders, if he wants to use the investment differently in the short term or if the guaranteed and currently achievable minimum return is already sufficient for him. In order to protect the interests of the founders, an investment agreement that provides for both a liquidation preference and a drag-along clause in favor of the investor should relate these two provisions to each other – for example by stipulating that the minority shareholders' obligation to sell only applies once a certain amount of the exit proceeds has been reached.

Summary of liquidation preferences

It can be concluded that liquidation preferences are an almost indispensable instrument for investors to secure investments and expected returns in risky investments. At the same time, there are also methods for founders in a structurally weaker negotiating position to contractually structure liquidation preferences in such a way as to prevent unreasonable disadvantages for themselves. However, as the example with the interaction of liquidation preferences and drag-along rights may have shown, a number of things need to be considered and calculated in advance of the contractual negotiations for various exit scenarios.

We will be happy to assist you with advice and support if you, as a founder or investor, are considering an investment and need expert help.