Liquidation Preference in Private Equity
Or: Why simply driving a hard bargain doesn't necessarily mean getting the best deal?
Over the last few years, financial institutions have been more risk conscious when investing new money in start-up and emerging growth companies (such as technology, IT, telecom, life- or bio-sciences companies). As a consequence, many Venture Capital1 funds have now accumulated large amounts of money, which are yet to be invested. At the same time, many companies that have survived the difficult last few years now require new (growth) financing. Where banks are (usually) reluctant to extend financing without receiving some (asset backed) security in return, Venture Capital investors are targeting opportunities that offer appropriate risk return profiles. Even though it would seem logical for an investor to negotiate the highest possible preferences in order to compensate for the risks involved in investing in such companies, this article will illustrate why merely stipulating a huge liquidation preference will not necessarily result in getting the highest return on investment.
In this article, I will first explain what a liquidation preference is (par. 2), followed by an overview of the main types of liquidation preference (par. 3 and 4), thus providing sufficient background to understand the various issues which may come into play when negotiating a liquidation preference: the overhang problem (par. 5) and the enforceability of a liquidation preference in combination with a drag-along right (par. 6). A quick reference to what is market practice is given in par. 7. Some practical tips for drafting a liquidation preference clause in the investment agreement are provided in par. 8. The relation between the articles of association and the investment agreement is discussed in par. 9. Finally, par. 10 contains the conclusion.