Liquidity preference means the asymmetrical distribution of the purchase price in favour of the investor, ensuring through this that the company’s founders or management are unable to benefit from the company financially should it not be possible to realise the company’s value appreciation potential. The clause thus protects the investor in a manner similar to anti-dilution protection against reckless promises of entrepreneurs and excessively high valuation demands.
Situations in which a liquidation preference is applied are listed frequently. These are, for example, mergers, divestments, reorganisation of operations, bankruptcy or a situation in which over 50% of the shares or IRP change hands. A liquidation preference is sometimes arranged through two different series of shares from which preferential entitlement to a share in the profits is given to the other of these in some ratio if the company’s assets are (see preference share, page 58).
Under a straight liquidation preference structure investors can sell their holding if the company’s value has fallen below the valuation at the time of the investment, and receive funds up to the amount to the amount invested in full themselves.
A participating preference entitles an investor to the return of the entire amount he or she invested and a specified share of surplus assets. Distribution of the surplus share can be full or capped. In a full structure, the investor is entitled to receive a pro rata share in the profits and in a capped structure to a given amount (generally 2–10X invested amount), after which the remainder is distributed to the other shareholders in proportion to their holding.
A capped participation liquidation preferenceis a variation of the previous structure. When the investors’ capital has been returned, the remaining profit is distributed first in proportion to the holding of preference shares to a given amount (usually 2–10X invested amount) and only afterwards in proportion to the holding of ordinary shares (founders).
A senior liquidation preference is based on two different series of shares in which preferential entitlement to a share in the profits is given first to the other (X euros) and only the surplus is given to the other share series. This solution is generally used in so-called bridge financing when rapid temporary funding is needed between investment rounds.
A multiple liquidation preference functions in the same way as a basic liquidation preference, but the original subscription price has a multiplier (usually 1.5–5). In some cases a combination of seniority and this structure may be used.
In theory, the company’s management and the founder shareholders should be entitled to the assets, as they are responsible for the company’s increase in value. On the other hand, however, the investor has borne the financial risk of success and the founder shareholders have gained the assets invested in the company as remuneration and bonus arrangements by working in the company.