Preferred Liquidation

Preferred liquidation is a critical term in the world of entrepreneurship and investments. Understanding its nuances can be the difference between a favorable deal and an unfavorable one. ILP Abogados guides you through the different types of preferred liquidation to help you make informed decisions.

Preferred liquidation is a relevant mechanism, more typical of venture capital than of private equity, that attempts to guarantee investors the return of their money before ordinary shareholders, such as employees and founders. It is designed to protect the interests of preferred shareholders and mitigate the risks associated with early-stage investment where the investment is more volatile and risky. Before going into detail, it is important to understand the use cases and limitations of liquidation preferences.

Liquidation preferences only apply to preferred shares. Such shares require specific issuance (Series A, Series B…) which are usually issued to investors during financing rounds. It should be noted that liquidation preferreds are not relevant for a market delisting, as such a delisting usually automatically converts all preferred shareholders into ordinary shareholders.

Although preferred liquidations offer an added level of protection to investors, they can also create complications and reduce the value of common stock. Founders and employees may have less incentive to work to maximize the value of the company if they are unlikely to receive a significant payout in the event of a sale or liquidation.

Typical Preferred Liquidation Arrangements

1) Non-Participating Liquidation Preference

• Definition: Investors recoup their initial investment before any profits are distributed among other shareholders.
• Advantages: Protects the investor in case of a low-yield sale.
• Considerations: Less attractive to founders, as it limits their share in the profits from the sale.

2) Liquidation Preference “Single Dip”

• Definition: Once investors have recovered their investment, they participate in the distribution of the remaining profits as if they were ordinary shareholders.
• Balance: Offers a fair middle ground between the interests of the investor and the founder.
• Strategy: Often used as a negotiable term to attract investors without giving up too much control.

3) Liquidation Preference “Either-Of”

• Definition: Investors can choose between recouping their investment (Non-Participating) or converting their preferred shares into ordinary ones and participating in the total distribution (Single Dip).
• Flexibility: Provides investors with the ability to decide the best course of action at the time of liquidation.
• Complications: Can lead to more complex negotiations and detailed structuring in agreements.

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Preferential liquidation, a poisoned candy

These types of clauses are very common in practice. However, you have to be very careful when negotiating them. This is because, if the Investor has a relevant right of first refusal, the benefit for the rest of the partners may become non-existent.

4) Examples of the previous 2) and 3), how they work. This cant´be considered as Legal Advise. Please, don´t copy and paste. This is serious: Hire a skilled law firm.

Liquidation Preference “Single Dip”

In a “Single Dip” Liquidation Preference clause, it could be stated as follows: “In the event of liquidation, dissolution, or sale of the company, investors will first receive the return of their original investment. Once investors have recovered their investment, they will participate in the distribution of the remaining profits on an equal footing with common shareholders.”

Liquidation Preference “Either-Of”

In an “Either-Of” Liquidation Preference clause, it could be stated as follows: “In the event of liquidation, dissolution, or sale of the company, investors will have the option to (a) receive the return of their original investment without participating in additional profits, or (b) convert their preferred shares into common shares and participate in the total distribution of profits along with other shareholders.”

Recommendation for specialized legal advice

• Importance of knowledge: Deeply understand each option and how it can affect your startup in the long term.
• Tailored advice: At ILP Abogados, we offer personalized advice to align your preferred liquidation agreements with your business goals.
• Strategic partner: We are not just your lawyers; we are your allies on the path to success.

Conclusion

Choosing the right preferred liquidation structure is crucial for the future of your startup. With the expertise and knowledge of ILP Abogados, you can navigate these complex decisions with confidence.

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