The liquidation preference clause in an investment agreement can serve as an effective instrument to guarantee the investor the repayment of at least a portion of the amount invested by them in the event of a liquidity event. We invite you to familiarize yourself with an article discussing the practical aspects of utilizing the liquidation preference clause in investment agreements.

What is the liquidation preference clause?

Incorporating the liquidation preference clause in an investment agreement ensures the investor receives repayment of at least a portion of the invested amount in the event of a liquidity event. Such an event could include the sale of the company, merger, division, or liquidation. The liquidation preference clause constitutes one of the mechanisms for protecting the investor’s interests, particularly in situations where the value of the company upon its sale does not cover the invested capital.

What forms can it take?

The liquidation preference clause comes in two forms: participating and non-participating. If the goal is to prioritize the investor’s satisfaction before other shareholders of the company (usually the founders), the participating form of the liquidation preference clause is employed. It is also possible to use a hybrid model that incorporates elements of both prescribed forms or introduce the maximum participation amount for the investor (the so-called cap).

When and why is it used?

The liquidation preference clause allows for determining the order and degree of division of funds obtained as a result of the company’s liquidation among individual shareholders.

In practice, when implementing the liquidation preference clause in investment agreements, the privileged party in the liquidation process is the investor. Securing their interests as a priority is justified, especially given the high risk of investment and the often substantial financial contributions made. This is one of the key reasons why investors seek assurance that, in the event of a company sale or liquidation, they will be guaranteed a sum equivalent to at least the amount invested in the company – regardless of the ownership structure or the amount received for the entire company. After meeting this condition and satisfying the investor, the remaining funds are divided according to the terms agreed upon by the parties.

In summary, the liquidation preference clause is often encountered in agreements with venture capital investors, serving as protection for their investments. Its precise terms are the result of negotiations between the parties and should be carefully tailored to the specifics of each investment and compliant with applicable law. In the legal and business context, the liquidation preference clause can be a significant element of an investment agreement aimed at safeguarding the interests of investors. However, its application should be carefully considered and adjusted to the specific circumstances of the investment and the applicable legal regulations.

We understand that this is a complex and demanding subject matter, therefore, if legal support in this area is needed, we invite you to contact the Hoogells team.