Partners’ Agreement: don’t overlook the “Liquidation Preference” clause

By 26 September 2018 June 18th, 2020 No Comments

Simply put, the Partners’ Agreement is no more than a contract that establishes the rules of the game between the owners of a company. The agreement should help you to have a clear idea of how your company is organised and how decisions will be taken, be it in more routine situations or in more complex ones, such as capital raises and the buying and selling of company shares.

The significance of understanding the Agreement

In any case, we won’t be able to negotiate advantageous contract conditions that align with our interests if we don’t know how the one or other clause affects us. To have a minimum guarantee in this sense, and in order to avoid unnecessary conflicts and misunderstandings, you simply have to make sure to read the agreement well. And it’s not enough to read it, you have to understand it too!

While there are many and varied clauses within the Partners’ Agreement that may be more “important” for you, with this post, we wanted to look in more detail at the famous Liquidation Preference clause. Knowing this clause well can save you more than one “headache” (while not knowing it, can generate many problems) and it needs to be observed that not everyone always interprets it correctly.

What is the “Liquidation Preference” clause?

First of all, it’s important to be clear about one thing: when we speak of “liquidation”, we don’t just refer to those situations where we dissolve companies and distribute what is left among creditors, we also refer to what we call “windows of liquidity” (partial or total sale) where company shares are converted into cash.

So then, when such a liquidity event occurs, there may be one investor that demands “preference” that is to say, he demands to be the first to recover his share of the money invested. The remaining capital will only be paid out according to prorate conditions among the remaining investors, once the “preference” demand of the first investor has been fulfilled. It is also possible that he demands two, three or more times the amount (double or triple Liquidation Preference), thereby becoming the first one to receive the capital invested or receive double of what he invested, etc. In this case, other investors will receive what they’ve invested only once this investor has received his pay-out, if there is anything left in the first place.

If this case presents itself, we have two possibilities. What we tend to think in the first instance is that the investor is abusing his position of power, establishing himself as the “saviour” of the company in need and/or entering as a company shareholder with an elevated ticket, which assures him a significant enough number of shares so that he can veto and impose his own will in a majority of key decisions. However, he may also be the one investor that aims to save the company in a moment where all others have already given up on it.

In other to illustrate this with an example and at the same time demonstrate that we cannot always call an investor “aggressive” if he demands a Liquidation Preference, let us imagine that an investor invests € 100K at a valuation of € 1M, which equals a 10% share of the company. In our hypothesis, the situation goes badly in a question of months and the company decides to liquidate its assets or sells off its assets for € 300K at a loss. In this context, if we keep to the percentage share rule, the investor only recovers 30K (loses 70K), having been the only one that believed in the company and having provided it with a life-saving capital injection so that it may recover and grow.

It suddenly doesn’t appear so hare-brained any more to think that such an investor deserves to recover the money he has invested before the remaining capital is distributed proportionally among all other investors. It is, of course, not the same to speak of a double or triple liquidation preference, as in this case, the request is much more difficult to justify.

How do we do it at Faraday?

In our case, we always try to be fair and honourable with all parties involved in the Agreement, aiming, as far as is possible, to align the interests of all those involved so that there are no comparative grievances. In this sense, as a general rule of thumb in situations of asset liquidations and the passing of shares from one owner to another, we consider it reasonable to distribute the corresponding capital provided proportionally among each investor until they recover their investment (or at the very least the maximum amount possible, if the amount that requires liquidation is lower than the price of the shares at the moment of entry). Should there be money left over, we distribute the remaining shares of the company’s capital in a prorate manner.

In conclusion, we’d recommend surrounding yourself with people that have experience in this remit, as these will be the people that add fundamental value from the very first conversations about the Agreement to conflict resolutions that cannot be resolved on the go. For this reason, Faraday disposes of a multidisciplinary team and the necessary legal assessment that allows us to represent the interests of our Partners in the best and most joined up manner possible, where otherwise we’d have to involve ourselves in necessary but often tedious legal and administrative questions that require time, a valuable and scarce resource.

By Javier Contreras Forns – Head of Compliance and Legal Affairs