In the world of venture capital, liquidation preferences are one of the most critical terms for both investors and founders. They dictate how proceeds from a sale, liquidation, or winding-up of the company are distributed among shareholders.
While they are designed to protect investors by guaranteeing a minimum return, their structure can significantly impact the amount founders and other shareholders ultimately receive.
This article explores the mechanics of liquidation preferences, the different types commonly seen in venture capital term sheets, and the implications for all parties. As part of our "Anatomy of a term sheet" series, we aim to demystify these terms and provide practical insights into how they operate in real-world deals.
A liquidation preference determines how proceeds are distributed to shareholders during a liquidation event, which can include:
Preference shareholders typically get paid before ordinary shareholders. The mechanics of liquidation preferences are defined by:
Example:
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Example
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Example:
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Liquidation preferences are standard in venture capital deals, but the specific terms vary depending on the stage of the company, market conditions, and investor negotiation power.
Founders should carefully review the BVCA Model Documents, which provide standard templates for preference share structures commonly used in UK deals.
Liquidation preferences directly impact the financial outcomes for all shareholders during an exit. For founders, understanding their implications is crucial to assessing the true cost of raising capital.
In companies with multiple funding rounds, liquidation preferences can stack, creating a liquidation preference stack. This means that investors in later rounds (Series B, C, etc.) may have their preferences satisfied first, leaving less for early-stage investors and founders.
Example:
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For founders, negotiating liquidation preferences is about balancing investor protections with preserving long-term equity incentives. Common strategies include:
Founders’ perspective |
Investors’ perspective |
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Motivations |
Founders aim to retain as much equity as possible and maximise their share of exit proceeds. They seek terms that incentivise long-term growth without overburdening the cap table with investor-favourable preferences. | Investors use liquidation preferences to protect their downside risk, ensuring they recoup their investment before ordinary shareholders receive proceeds. This is particularly critical for high-risk, early-stage investments. |
Preferred position |
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Risks |
Aggressive preferences, especially stacked or uncapped participation, can leave founders with little to no payout in low-to-mid-value exits. | Overly aggressive preferences may deter founders, reducing their motivation to grow the business, and complicate future fundraising efforts. |
Where they align |
Both parties benefit from a balanced structure that aligns incentives and attracts future investment. Non-participating preferences or capped participation can strike a fair balance, ensuring investors are protected while founders retain motivation to build long-term value. |
Liquidation preferences are a vital term in any venture capital deal, shaping how exit proceeds are distributed and protecting investors’ returns. Founders must understand their mechanics and negotiate terms that balance protection with equity alignment. By carefully modelling outcomes and aligning interests, founders and investors can create structures that incentivise success for all parties.
Read the next article in our ‘Anatomy of a term sheet’ series, where we’ll examine the mechanics of share options, their impact on the cap table, and the considerations for both founders and investors.
If you're navigating the complexities of venture capital term sheets or preparing your business for investment, our experienced team is here to help. Get in touch to discuss how we can support you in securing the right deal for your business.
Our 'Anatomy of a term sheet' series breaks down each critical section of a venture capital term sheet, offering technical insights and practical real-world examples to help founders with their fundraising journey.
Our aim is to demystify term sheets and empower founders and their advisors to navigate negotiations with clarity and confidence.
Anatomy of a Term Sheet OverviewChris Dyson
Partner and Head of Technology Sector
+44 (0)117 321 8054 c.dyson@ashfords.co.uk View moreRory Suggett
Partner and Head of Corporate
+44 (0)117 321 8067 +44 (0)7912 270526 r.suggett@ashfords.co.uk View moreAndrew Betteridge
Partner & Head of the Commercial Services Division
+44 (0)117 321 8063 +44 (0)7843 265362 a.betteridge@ashfords.co.uk View more