It is THE most critical legal clause in your fundraising round. Most entrepreneurs aren't even aware of it, yet it is the one that can radically shift the value of a deal: Liquidation Preference.

While often overlooked, it has become nearly systematic in Series A rounds and beyond. Liquidation preference protects investors by ensuring they receive a minimum return on their investment before founders and other shareholders split the remaining exit proceeds. This clause can be included in the Articles of Association or within a Shareholders' Agreement (SHA). To help you fully understand your cap table, here is our dedicated article on the subject.

Defining the Liquidation Preference Clause

The liquidation preference clause allows investors to receive the proceeds from the sale of the company first, up to the amount of their initial investment. The remainder is then shared among the other partners. The economic objective is clear: the investor wants to receive—in priority over any other partner—the very first monetary distributions made by the company, whether in the form of dividends, liquidation bonuses, the sale of significant assets, or the sale price of the company's shares.

Legal Framework

In France, this clause is governed by Article L228-11 of the Commercial Code, which allows any joint-stock company to create preferred shares with specific rights of any kind at the time of incorporation or during its existence. These specific rights may include the right to receive a priority dividend paid before other partners.

A Simplified Example to Better Understand

Imagine you close a €5M Series A at a €20M post-money valuation. Five years later, the founders sell the company for €10M.

• Scenario 1: Without Liquidation Preference

  • Investors: 25% of equity x €10M = €2.5M cash-out (resulting in a €2.5M loss).

  • Entrepreneurs: 75% of equity x €10M = €7.5M cash-out.

• Scenario 2: With Liquidation Preference

  • Investors recover their initial investment first: €5M.

  • Entrepreneurs take the rest: €10M - €5M = €5M cash-out (half as much as in Scenario 1).

Liquidation Preference: What is the Impact on Founders?

It is crucial for entrepreneurs to understand the terms of the liquidation preference to evaluate its potential impact on an exit, specifically:

• Liquidation Seniority: The hierarchy of who gets paid first.

• Participation Cap: Limits on the investor's total payout.

• Associated IRR: Any guaranteed internal rate of return linked to the preference.

• Founder Carve-out: A set amount reserved to ensure founders walk away with proceeds.

• Participating vs. Non-Participating: Determining if investors "double-dip" into the remaining pool.

How is the "Waterfall" Structured?

The distribution is generally organized in three stages:

1. Carve-out: An equal distribution (generally around 10-15% of the exit price), allowing founders and early investors/partners to receive some funds immediately.

2. The Preference: The remaining proceeds are allocated to preferred investors until their initial investment is recouped (potentially plus if it’s more than 1x), minus any amounts received in the first stage.

3. The Residual: If proceeds remain after the first two steps, the balance is distributed among all shareholders. A preferred investor only benefits from this third step if the clause is "Participating."

Conversion Rights

The clause must be accompanied by a right to convert preferred shares into common shares. In a very large exit, a preferred investor might find that their "priority" amount is actually lower than what they would receive based on their pro-rata percentage of the total capital. The conversion right allows the investor to return to a common share status if it is financially more profitable.

Strategy for Founders

What is favorable for one is unfavorable for the other. If investors are privileged, other partners will receive less than expected.

Our Advice for Entrepreneurs:

• Raise funds when you need them the least to be in a position of strength and avoid these types of clauses.

• Negotiate the percentages: Aim to ensure investors do not guarantee 100% of their investment in all cases. Risk and reward should be shared.

We have simplified these concepts as much as possible to make this clause understandable for everyone.