Liquidation preference – what is it?

In the world of venture financing, the terminology is not always crystal clear. One
such example is the term “liquidation preference” or in its more popular short form – “liq pref”.

By liquidation preference is most often meant that a holder of a preference share will have a certain priority above holders of other classes of shares. Most commonly, the liquidation preference right means a right to receive dividend or liquidation payments, or any other transfer of value from a company to its shareholders, with priority ahead of any other shareholders. The liquidation preference normally corresponds to the invested amount, i.e. the original purchase price for the preference shares in question, with our without a yearly interest factor on top (hereafter the preferred amount). Once the preferred amount has been fully repaid, payment can be made on any other classes of shares, if there is any funds left that is! As payment of dividend, liquidation proceeds and alike is governed by the company’s articles of association, liquidation preference terms needs to be clearly defined therein. As a preference shareholder not only wants to have a priority in case of payment from the company, but also in respect of any payments made by others to shareholders in case of sale of shares etc, the preference terms and conditions also needs to be outlined in a shareholders agreement between all shareholders in the company. This way, the preference shareholder can be sure that he will have a preference to all payments made to shareholders in respect of shares in the company, i.e. both for payments coming from the company and payments coming from buyers of existing shares.

The example above, whereby the preference shareholder receives the preferred amount first, and then other shareholders receive the residual (if any) is called a “one time preference without participation” as the preference shareholder receives one (1) time his investment back, but thereafter has no right to anything further. Such preference right is normally combined with a “conversion right” whereby the preference shareholder can chose to convert his preference shares into ordinary shares (i.e. give up his preference right) and only participate in a sale, receive dividend or alike on a pro rata basis like the other shareholders (i.e. receive his percentage of any funds based on the number of shares he holds out of the total number of shares in the company). Hence, through the liquidation preference and conversion right, a preference shareholder can make sure to always opt for the most favourable solution if and when there is a payment from the company or sale of shares. In short, he will stay with his preference right or convert into ordinary shares depending on which solution that gives the highest payment on his shares.

Liquidation preference provisions can sometimes be more brutal than the “one time without participation” version described above. For example a “two time with participation” liq pref would mean that the preference shareholder first shall receive two (2) times the preferred amount and in addition thereto, also participate on a pro rata basis when the residual is distributed among shareholders. Obviously, this could be argued to be a favourable liq pref provision for the preference shareholder, but we should leave for the specific situation to determine whether it is justifiable or not.

For more information, please contact Oskar Belani.

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