Liquidation Preference

Also known as: Liq Pref, Liquidation Privilege, Participating Preferred, Non-participating Preferred, Tasfiye Tercihi

In short

The right of an investor to receive its investment, or a multiple of it, before other shareholders on a sale, liquidation or similar exit event.

A liquidation preference ensures that the proceeds of a sale, liquidation or similar exit are distributed first to the investor and then to other shareholders. If the company is sold below the investment valuation, the investor at least recovers its investment.

Types

Multiple: The amount the investor receives first, expressed as a multiple of its investment. 1x is most common; higher multiples are seen in investments made in difficult times.
Non-participating: The investor either takes the preference amount or shares in the sale proceeds pro rata as if converted to ordinary shares, whichever is higher.
Participating: The investor first takes the preference amount and then also shares in the remaining proceeds pro rata. A cap on total return is sometimes added.
Ranking: If preferences were granted in several rounds, it should be decided whether the latest investor is paid first (stacked) or all investors rank equally (pari passu).

Example

Suppose an investor acquired 20% of the company for USD 2 million and the company is sold for USD 5 million. With a 1x non-participating preference, the investor either takes USD 2 million or USD 1 million pro rata, and chooses USD 2 million by using the preference. The remaining USD 3 million is shared among the other shareholders. With a participating preference, the investor first takes USD 2 million and then a further USD 600,000, being 20% of the remaining USD 3 million.

Application under Turkish Law

The Turkish Commercial Code permits a privilege over liquidation proceeds (TCC Art. 478); this privilege applies through the articles of association where the company is actually liquidated. However, most exits happen through the sale of shares, not liquidation. Because the sale price is paid to the shareholders, not the company, the preference can then only be applied through a distribution undertaking between the shareholders. The liquidation preference is therefore written both into the articles through preferred shares and into the shareholders’ agreement as provisions on the distribution of sale proceeds, supported by the drag-along right.

Frequently Asked Questions

What does a 1x non-participating liquidation preference mean?

On a sale, the investor either receives one times its investment first, or waives this preference and shares in the sale proceeds pro rata, whichever is higher. It is the most common and, for founders, the most balanced form of preference in practice.

Does a liquidation preference apply only when the company is liquidated?

No. Despite its name, a liquidation preference is drafted to apply also on exit events such as a sale, merger or transfer of substantially all assets of the company. These events should be defined clearly in the agreement.

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