Preferential liquidation, a poisoned candy

The preferential liquidation clause is a type of covenant widely used in agreements between partners.  These covenants are usually introduced by investors to ensure the recovery of their investment and an agreed return.

This formula is commonly used in the field of startups. Especially when the volume of the company allows to exceed the financing via “FFF”. (FFF = Family, Friends and Fools)

Professional investors usually require the incorporation of these clauses to “ensure” the return on investment. Investments in startups have a high risk. And when Series A or B rounds are reached, the investment can reach astronomical figures.

The essence of preferential liquidation

This clause is usually an investment incentive for professional investors. This is because when the investor leaves, the company value should be higher than when he entered. But this is not always the case. Sometimes when the investor leaves, the company value is not higher, but lower. In that case, this clause is of vital importance. Since it regulates how the amount derived from the divestment will be distributed among the partners.

This clause comes into play in the following scenarios:

1. Exit of the investor.
2. Capital reduction.
3. Distribution of dividends.
4. Sale of 100% of the company.
5. Merger with another entity.
6. Absorption of the company by another.
7. Purchase and sale of assets and liabilities.

In any case, it is the clause itself that will mark when it is applied. This is known as “liquidity events”, “liquidity windows” or “triggers”.

The Capital Companies Act makes it possible to issue participations or shares with preferential rights.  However, the wording of these clauses is not established. Therefore, they are open to an agreement among the partners.

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Consequences of the nullity of corporate resolutions

The action to contest the social agreements expires within one year. However, when the agreements are contrary to public order, the action will not expire nor will it be time-barred.

What does the preference consist of?

In short, it implies the receipt of potentially higher amounts than those that would correspond if this covenant did not exist. In the event of a liquidity event, the amounts of the beneficiaries of the clause are settled with preference. This right is not automatic, but can be exercised or not.

The shares grant a preferential right to receive an amount equivalent to the investment. Or even the initial investment plus a multiplier. This multiplier is agreed in advance.

As investment rounds are negotiated, the investor usually agrees on a minimum guaranteed return. This minimum will accrue in the event of a liquidity window.

Of course, the investor has a preference over the guaranteed minimum, but this does not assure the return of his investment. In other words, if the company at the time of sale is worth less than at the time of investment, there will be a loss. And the investor will suffer it like the rest of the partners.

Types of preferential liquidation clauses

This type of clause is not easy to draft, negotiate or apply. The most commonly used are the following:

1. Non-participatory preferential liquidation: This type of clause is intended to favor the startup and the founding partners. In this case, the investor decides whether or not to activate the preferential liquidation. In any case, it will be a “single dip”. That is, the investor will receive his initial investment with the corresponding multiplier and nothing else.

If this right is not exercised, he/she will receive the share corresponding to his/her percentage of participation in the capital stock. The same as the rest of the partners. If he/she exercises it, he/she will receive his/her investment plus the multiplier. The remainder will be distributed among the ordinary partners.

2. Participatory preferential liquidation: it is more favorable to the investor. The “double dip” rate is applied. In this case, the investor will receive his/her investment with the multiplier and, in addition, will participate in the subsequent distribution. Of that which exceeds his/her return.

3. Limited participatory preferential liquidation: this is an intermediate type of liquidation between the two previous ones. The double dip modality is applied to investors, but with limitations. A maximum return limit is agreed. Once the limit is reached, there is no participation in the distribution of the excess.

Compensation mechanisms

In order to avoid disproportionate situations in favor of investors, compensation mechanisms are usually agreed upon. These mechanisms refer to:

1. Quantitative limits,
2. Time limits,
3. Conditionality of their application according to the company’s turnover or results.

Conclusion

This type of clause is very common in practice. However, great attention must be paid 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. For that reason it is necessary to negotiate these rules with moderation, common sense and trying to compensate all the parts. Above all, to the managers of the company (in such a way that they are not demotivated).

If this article has been of interest, we also suggest you to read the following article published on our website:

The 10 Key Steps of Mergers and Acquisitions in How to Sell a Company

The 10 steps of an acquisition (Mergers and Acquisitions)

How to acquire a company: LBO, MBO, MBI, BIMBO