Liquidation preference rights

Typically, a preference right will stipulate that, on a liquidation or exit event, the holders of the shares that have the preference right attached will, once all of the company's liabilities are satisfied and ahead of any other distribution to shareholders, receive an amount equivalent to their initial investment for such preferred shares or, less often on venture capital transactions, a multiple of that investment amount. 

After satisfying the preference rights by the payment of the relevant amount, any remaining liquidation funds or exit proceeds are then available for further distribution to the shareholders. On venture capital transactions the approach to this "next phase" varies on a deal by deal basis depending on the dynamics and commercial position but common approaches in venture capital include:

• a "fully participating" or "double dip" scenario where the remaining funds are simply distributed pro rata amongst all shareholders, including both preferred and ordinary shareholders; 
• a "simple participating" scenario where the ordinary shareholders next receive an amount equivalent to their original investment after the preferred shareholders' preferences are satisfied, following which the remaining proceeds are further divided among all shareholders on a pro rata basis; or
• an "as converted" or “non-participating” scenario where there is no participation for preference shareholders beyond their preference amount. Instead, at the point in time where the funds available for distribution are such that, if the funds had been distributed pro rata across all classes of share as if one class, they would result in a higher amount received by the preference shareholders than their preference amount, then the preference shareholders would instead receive this higher amount as if all of the shares had been of the same class.   

The above is a condensed list of some simple and "classic" venture capital liquidation preference positions but, ultimately, the size and structure of a liquidation preference right will be subject to bespoke negotiations, reflecting the associated risk levels of each investment round. Factors such as the company’s valuation and market conditions critically influence these negotiations. Higher risks necessitate higher returns, hence more robust liquidation preferences. 

In summary, the mechanisms surrounding preference rights on any capital distribution will be at the heart of a negotiation process on a venture capital investment and provide a safety net for investors to protect their financial interests during critical corporate transactions. It is crucial then that appropriate care, diligence and advice is taken when considering such terms.

DWF has the largest venture and growth capital group in the UK with over 85 lawyers in 10 offices, and supports investors and companies across several sectors including financial services, technology, media and telecommunications, life sciences and healthcare and real estate and infrastructure. 

If you have queries on any of the issues covered in this article please contact one of our experts.