Liquidation Preference
Liquidation preference specifies the order and amount of payments to investors in a liquidation event, such as the sale, merger, or dissolution of the company. It determines how proceeds from the liquidation are distributed among shareholders. It ensures that certain investors receive their invested capital back before any remaining proceeds are distributed to other shareholders.
What is the importance of liquidation preference?
Liquidation preference is required for several key reasons. Let us take a look at that:
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Risk mitigation
Startups and early-stage companies are inherently risky investments. Liquidation preference ensures that investors get a better chance of recouping their investment in the event of liquidation. This includes a sale or dissolution of the company. With liquidation preferences, startups make their investment attractive to potential investors to reduce the risk.
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Incentivize investment
As they have a claim on the company’s assets, investors are willing to commit large sums of money. This is crucial for startups to grow and scale their operations. In a competitive funding environment, having favorable liquidation preference terms helps a startup secure investment over others.
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Interest alignment
Early-stage investors take significant risk by investing in unproven companies. LP ensures that these investors are compensated for taking higher risk. LP balances the returns between different classes of investors. It ensures that those who invested earlier are rewarded appropriately.
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Protection during losses
If a company is sold for less potential or is liquidated, LP ensures that investors get their money back before being distributed to common shareholders. This reduces the losses for investors, makes it more palatable for them to invest in high-risk ventures.
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Encourage responsibility
Liquidation preferences incentivize founders and management to achieve higher valuations for the company. Here, investors need to be paid back first before they benefit from the proceeds. Investors are prioritized in case of an early or low-value exit, LP discourages founders from selling the company prematurely at a low price.
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Negotiation
Clear liquidation preference sets the right expectations between the company and its investors. The financial hierarchy and the proceeds distribution prevents conflicts later. LP is structured in various ways (non-participating, participating, capped participating) to suit the specific agreements between investors and the company, allowing flexibility around negotiations.