Meaning
Distribution priorities define the order in which proceeds are paid to shareholders during an exit. Liquidation preferences ensure that certain investors receive their initial capital back, often with a multiplier, before common shareholders receive any funds. They govern the division of value in a sale or dissolution.
Capital Protection
Preferred investors use these rights to mitigate the risk of losing their investment in a low value exit. When liquidation preferences are applied, they act as a floor that ensures a certain level of return regardless of the total exit price. This protection is especially relevant in scenarios where the company is sold for less than the amount of capital raised.
Return Hurdle
Founders must achieve a high enough exit value to clear the claims of the preferred shareholders. If the total proceeds do not exceed the sum of all liquidation preferences, the common shareholders may receive nothing from the sale. This reality places a large cost on the founder, who may work for years only to see all the value go to the investors.
Participation Clause
Some agreements allow investors to both receive their preference and share in the remaining proceeds with the common stockholders. Liquidation preferences with participation further increase the hurdle for founders and employees. This arrangement stops being a factor only when the exit value is large enough that the participation is capped or the investors choose to convert to common stock.
