Explaining investment terms: Liquidation preference and deemed liquidation
The liquidation preference is a right which can be required by venture capital investors in recognition of the risk they bear on their capital contribution. While there are many variations, the liquidation preference typically provides that, in the event the company is liquidated or subject to a deemed liquidation (see below), the preferred shareholders will receive a certain amount of the proceeds before any other shareholders. This preference amount may be equal to the amount of the preferred shareholders’ investment, or a multiple of it.
The remaining proceeds are often then shared amongst the preferred and ordinary shareholders. There are numerous ways in which this may be effected, but the most common are:
- the remaining proceeds are shared pro rata, according to their percentage shareholding, among the preferred and ordinary shareholders (in which case the preferred shares are considered fully participating, i.e. after receiving the preference amount, the preferred shareholders participate fully with the ordinary shareholders in sharing the remaining proceeds);
- after payment of the liquidation preference amount, the ordinary shareholders may catch up by receiving an amount equal to the amount paid by them or credited as paid by them for their shares, thereafter the proceeds being shared out on a pro rata basis between all shareholders (in which case the preferred shares are considered simple participating).
The size and structure of the liquidation preference will be negotiated to reflect the risk inherent in each investment round: the higher the risk, the higher the required return. Many factors (including the valuation of the company) will be considered in this calculation.
Venture capital investors usually require that the liquidation preference applies not only in connection with a liquidation or winding up of the company, but also in the case of a deemed liquidation, a term usually defined to include a merger, acquisition, change of control or consolidation of the company, or a sale of all or most of its assets, but sometimes also includes an initial public offering (IPO) or a qualified exit (see Exit).
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