Liquidation preference: This is how VCs protect themselves in crises -
to the disadvantage of founders

Liquidation preference: This is how VCs protect themselves in crises - to the disadvantage of founders
Liquidation preferences are again being used more often in financing rounds. An M&A expert explains what the special right means.

Founders who want to raise money today have to bite the bullet when negotiating with investors. A guest article by Christian Saxenhammer, Managing Director of the Berlin-based M&A advisory firm Saxenhammer & Co. Corporate Finance GmbH. He has already accompanied and prepared hundreds of company acquisitions and sales. Since the beginning of the Corona pandemic, the market for venture capital has been on a roller coaster: sometimes there is more, sometimes less venture capital. Currently, there is restraint in the market again. No wonder that new investors, who bring fresh capital and are courted accordingly, demand special rights. And not in the form of more voting rights, but in the form of more money in the event of an exit.
This works with the help of the liquidation preference. Since the market is currently more volatile again and venture capital firms are currently sitting on the longer end of the stick, they also get this. Depending on the negotiation situation, the market situation with regard to the availability of venture capital or the risk profile and industry of the start-up, founders and investors should or must agree to this. For in return, they receive urgently needed capital so that things can continue. Important in advance: Liquidation preference is not necessarily about liquidation in the literal sense, but about the exit of the start-up in general. However, the new investor wants to hedge against a negative scenario. Liquidation preferences act as protection for down rounds, but also for undesirable scenarios such as a sale at a poor purchase price "below value" or liquidation, i.e. insolvency. The investor uses the liquidation preference to hedge his investment even if the company performs poorly. This signals to the market that one expects lower valuations in the meantime, even if one believes in the company in the long term (otherwise one would not invest). In addition, the principle of "last in, first out" applies. Preference is given to the one who got in last. Ideally, there is an excess return - for the new investor Liquidation preference is often used in venture capital contracts, but it exists elsewhere as well. It contractually stipulates the payout order in the event of a company liquidation and thus determines who gets paid first and how much is paid if a company has to be liquidated. There are several possibilities for the arrangement. On the one hand, as "1x", which means that you are the first to get back 100 per cent of your investment. If, for example, the investment amounts to one million euros and the sales price is exactly this amount, all other shareholders are left empty-handed. However, there are also variants in which interest is also paid with a factor, for example "invested capital x 1.90". This is the investor's repayment expectation, whereby the real proceeds naturally depend on the sale price. An "allowable liquidation preference" means that the proceeds from the liquidation preference are credited against the pro rata share (i.e. the arithmetical share in the assets, for example 25 percent) of the sale proceeds. In the case of prorata proceeds that exceed the liquidation preference, this instrument is therefore neutral. Founders have to bite the bullet The "non-creditable liquidation preference", on the other hand, is based on a positive scenario and - as the term suggests - is not credited. Here, in addition to the liquidation preference, the investor also receives his prorata share to which he is entitled. In this way, he achieves an excess return - and thus naturally always more than the other investors and founders. A clear preference even for fair-weather periods. The most common form, however, is the chargeable liquidation preference.
Liquidation preferences are in vogue and are being used more often again because of the high level of uncertainty. They thus also reflect the increased investor scepticism about the economic outlook. Depending on their negotiating power, founders currently have to bite the bullet; at best they can extract a liquidation preference.

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