Liquidation preference is a clause in a contract that determines the payout order in case a company is sold, shut down, or goes bankrupt. It's often used in venture capital contracts to ensure that investors (preferred shareholders) get paid before other parties involved, such as founders or employees (common shareholders).
If a company is liquidated, the proceeds from the liquidation are used to pay off the company's creditors and investors. Liquidation preferences stipulate that certain investors get paid before others. Investors who have a liquidation preference are typically those who hold preferred shares, while common shareholders are paid after preferred shareholders have received their agreed-upon returns.
For example, if an investor has a 1X liquidation preference and invested €5 million in a company, they are entitled to receive the first €5 million from any liquidation event before any other distributions are made. Any remaining funds are then distributed to the other shareholders.
This mechanism provides downside protection for investors by ensuring they recoup their initial investment in the event of a company's underperformance or failure. However, the specific terms of liquidation preferences can vary widely and are often a critical point of negotiation between companies and their investors.
