Why do business angels agree to preferential settlement clauses?

For an investor, be it a business angel or a venture capital fund, agreeing a preferential liquidation clause when investing in a start-up makes sense:

• Assert the investor’s position, when it really matters in society. Startup capital is ephemeral and consumed quickly. This means that the investor in the first rounds loses relevance very quickly and becomes someone who can be replaced. These clauses strengthen their position when they still have negotiating power.
• Guaranteed recovery of the initial investment: The preferential liquidation clause gives the investor the right to receive, in the first place, an amount equivalent to his initial investment, in preference to the other partners. This gives him the assurance that he will at least get back the investment he has made, even if the start-up is not successful.
• Maximising return on investment: The preferential liquidation clause can be agreed with a multiplier, which indicates how many times the amount of the initial investment will be received in case of sale or liquidation of the start-up.

In general, preferential liquidation clauses are a useful tool for investors, as they provide them with greater security and a higher potential return on investment. However, it is also important to note that these clauses can reduce the capital available to the founding partners and other investors, which can hinder the startup’s growth.

In the case of business angels, who often invest in early-stage start-ups, the preferential liquidation clause is an even more important tool, as the risk of failure is higher.

Some examples of the typology of preferential settlement clauses:

• Simple preferential liquidation clause:

he investor first receives the amount of his initial investment.

• • Example of a simple preferential settlement clause :
  • Article 15. Preferential liquidation: In the event of sale or liquidation of the company, business angel investors shall be entitled to receive, in the first instance, the amount of their initial investment, in preference to the other partners.
  • This clause provides that, in the event of sale or liquidation of the start-up, the business angels will be entitled to receive, in the first instance, the amount of their initial investment, in preference to the other partners. This means that even if the start-up is not successful and is sold for less than the total amount of the investment, the business angels will get back at least the investment they have made.
  • In this example, the preferential liquidation clause is simple, as it does not include a multiplier. This means that the business angels will first receive the amount of their initial investment, and the other partners will receive whatever is left over.

• Participatory preferential liquidation clause:

The investor receives, in the first instance, the amount of his initial investment plus a pro rata share of the remaining profits.

• • Example of a participatory preferential liquidation clause: In the event of a sale or liquidation of the company, business angel investors are entitled to receive, in the first instance, the amount of their initial investment, plus a pro rata share of the remaining profits.

• Preferential liquidation clause with redemption:

The investor has the option to redeem his initial investment, in which case he will not be entitled to receive any share of the remaining profits.

• • Example of a preferential liquidation clause with redemption: Business angel investors will have the option to redeem their initial investment, in which case they will not be entitled to receive any share of the remaining profits.

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Is it common that not all investors have agreed preferential settlement clauses?

Yes, in fact, it is very common that not all investors have preferential liquidation clauses. Preferential liquidation clauses are an important tool for investors, as they provide them with greater security and a higher potential return on investment. However, they can also be controversial, as they can reduce the capital available to the founding partners and other investors, which can hinder the startup’s growth.

It is more common in cases where business angel investors can request a preferential liquidation clause. For example, if the business angel investor is investing a large amount of money, or if the start-up is at a very early stage and the risk of failure is higher.

Ultimately, the decision whether or not to include a preferential liquidation clause is a decision to be made by the founding partners of the startup and the investors. It is important to carefully negotiate this clause so that it is fair to all parties.

Factors that may influence the decision whether or not to include a preferential settlement clause include:

• The startup’s stage of development: Preferential liquidation clauses are more common in early-stage startups, which carry a higher risk.
• The size of the investment: Preferential liquidation clauses are more common for larger investments, which carry higher risk.
• The risk profile of the investor: Investors with a higher risk profile may be more willing to accept a preferential settlement clause.
• Negotiations between the founding partners and the investors: The decision whether or not to include a preferential liquidation clause is a negotiation between the founding partners and the investors.

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