Liquidation Preference

A liquidation preference gives certain investors the right to receive a defined amount first in a sale or liquidation. Only after that is the remainder distributed to the other shareholders. This protects investors by helping them recover at least their invested capital if needed. The design follows two dimensions.

The first is size, expressed as a multiple of the amount invested. One times is market standard in German venture capital, while higher multiples appear mainly in difficult markets and in down rounds. The second is participation in the remainder: under the non-participating variant the investor must choose between taking the preference and instead sharing pro rata in total proceeds, which is better at high sale prices. Under the participating variant the investor first takes the preference and then additionally shares in the remaining proceeds, which burdens the other shareholders considerably more and is therefore often subject to a cap. The ranking between several financing rounds is added, structured either as a stack by round or on an equal footing.

The economic effect shows up above all in mid-range exit scenarios: where the total of all preferences exceeds the sale price, founders and employees receive nothing despite substantial percentage holdings, which is why separate management incentive arrangements are often made in such cases. Comparing the total of all preferences with the expected valuation is decisive in negotiation, because that relationship determines from what sale price founders and employees participate at all. After several rounds the sum of preferences not infrequently exceeds the realistically achievable price. Maintaining an updated waterfall in every round and, where necessary, securing the team's participation through separate arrangements is therefore advisable.