Liquidation Preference

What is a liquidation preference?

Liquidation preference denotes the contractually agreed right of an investor to receive a fixed amount first out of the proceeds of a sale of the company or a dissolution of the company (liquidation). Also in use are the German term Erlöspräferenz and, in short form, liq pref. The priority amount usually equals the invested capital or, if agreed otherwise, a multiple of it. Figuratively speaking, the investor takes its stake out of the common pot first, before the rest is distributed.

The liquidation preference is one of the core economic terms of a venture capital financing. It is agreed in the term sheet, the outline paper of the round, and implemented in the participation agreement, the shareholders' agreement and the articles of association. All other shareholders are affected, whose share of the proceeds falls because of the priority. Employees with virtual shares under an ESOP are indirectly affected, that is, contractual payment claims measured by the sale proceeds. Their payout usually depends on the proceeds of the common shares, the shares without priority, which are generally held by founders and early shareholders. Every euro of priority therefore also reduces their payout.

Purpose and components of a preference clause

The preference protects the investor against a sale below the valuation at which it came in. The risk of loss at low and medium proceeds is thereby borne by the subordinated shares. It also explains why investors accept valuations that they would not pay for shares without priority. Model shareholders' agreements regularly contain such a clause; it is made up of the following parameters:

• Preference amount: usually the entire investment amount, that is, the nominal amount of the new shares (the part that goes into the share capital), premium (the additional price above it) and any additional payments into the capital reserve under Section 272(2) No. 4 of the German Commercial Code (Handelsgesetzbuch, HGB).
• Multiple: one times (1x) or a multiple of the investment amount.
• Participation in the remaining proceeds: whether the priority amount is credited against the share to which the investor is entitled by its shareholding percentage, or whether it also participates in the remaining proceeds.
• Cap and ranking: a maximum amount for the total payment and the relationship of the preferences of several rounds to one another.
• Surcharges: interest on the preference amount or accrued preferred dividends.

Variants of the liquidation preference

Creditable preference (non-participating)

With the creditable or non-participating preference, the investor receives the higher of two amounts: its preference amount or the share of total proceeds corresponding to its percentage. There is no double servicing from the same proceeds. The threshold above which the percentage exceeds the priority is explained in the entry on non-participating liquidation preference.

Non-creditable preference (participating)

With the non-creditable or participating preference, the investor first receives its preference amount and then participates in the remaining proceeds with its full percentage. In practice this is called the double dip, because the investor is served twice. Compared with a pure distribution by percentages, it thus receives a fixed additional amount (the preference amount less its percentage share of it), which weighs heaviest at medium sale prices.

Non-creditable preference with a cap

The non-creditable preference is often given a cap, for example at two or three times the investment amount. Once it is reached, the investor does not participate in further proceeds until its percentage share of total proceeds exceeds the cap; it then receives that share.

Ranking between the series

With several financing rounds, the series (such as Series A and Series B), the contract sets the order of the preferences. With a tiered ranking (stacked), the most recent round usually goes first. With equal ranking (pari passu), scarce proceeds are divided in proportion to the preference amounts. The effect across several series and sale prices is shown by a waterfall analysis.

Triggers: exit and liquidation

Despite its name, the preference rarely applies in a liquidation in the company-law sense. It is usually triggered by events that the contract treats as equivalent to a liquidation (liquidation events). Customary are:

• the dissolution and winding up of the company,
• the sale of the majority of the shares with a change of control (share deal),
• the sale of all or substantially all assets by the company itself (asset deal), often including an exclusive licence of material intellectual property rights,
• mergers and reorganisations after which the existing shareholders lose the majority.

An IPO generally does not trigger the preference. Participation agreements mostly provide that the preferential rights lapse with the IPO; the GmbH is converted into a stock corporation (AG) beforehand for this purpose.

Implementing the liquidation preference in the GmbH

German GmbH law (the law on the German limited liability company) distributes profit and liquidation proceeds in proportion to the shares. The articles of association may set a different standard (Section 29(3), Section 72 of the German Limited Liability Companies Act, GmbHG). The GmbH does not have a statutory share class with priority such as US preferred stock represents. The priority arises through proceeds distribution rules in two places.

Shareholders' agreement: sale proceeds

In a share deal, the acquirer pays the purchase price to the selling shareholders; the articles of association do not capture this payment flow. The preference is therefore set out as a proceeds distribution arrangement in the shareholders' agreement. This arrangement is contractual in nature, so it binds only the contracting parties. In the purchase agreement it is reflected through different purchase prices per share and a payment schedule. A drag-along obligation (drag-along) ensures that shareholders unwilling to sell also sell on these terms.

Articles of association: distributions and winding up

If the proceeds flow first to the company, for example in an asset deal, they reach the shareholders only through distributions or the distribution of the liquidation assets. For this the distribution key must be in the articles of association. They bind every future shareholder, the shareholders' agreement only once that shareholder has joined.

Amendments to the articles of association require three quarters of the votes cast and notarisation (Section 53 GmbHG). If the distribution key is changed afterwards to the detriment of individual shareholders, according to the prevailing view their consent is additionally required; in a funding round, all shareholders generally take part in any case. The shareholders' agreement is usually also notarised because it contains obligations to transfer shares (Section 15(4) GmbHG).

Worked example: calculating the distribution of proceeds with a liquidation preference

An investor has invested EUR 10 million at a post-money valuation of EUR 50 million and holds 20%. The other shareholders together hold 80%. Three simple preferences are compared: creditable, non-creditable without a cap and non-creditable with a cap at three times the investment amount (EUR 30 million). In each case the proceeds distributed are those that remain for the shareholders after deduction of debt and transaction costs.

• Proceeds EUR 30 million, creditable: 20% would give EUR 6 million, the priority of EUR 10 million is higher. Investor EUR 10 million, other shareholders EUR 20 million.
• Proceeds EUR 30 million, non-creditable, with or without cap: EUR 10 million plus 20% of EUR 20 million = EUR 14 million. Other shareholders EUR 16 million.
• Proceeds EUR 130 million, creditable: 20% of EUR 130 million = EUR 26 million. Other shareholders EUR 104 million.
• Proceeds EUR 130 million, non-creditable without cap: EUR 10 million plus 20% of EUR 120 million = EUR 34 million. Other shareholders EUR 96 million.
• Proceeds EUR 130 million, with cap: the EUR 34 million is limited to EUR 30 million, the percentage of EUR 26 million is below it. Other shareholders EUR 100 million.

From EUR 50 million of proceeds, the investor without a cap always receives EUR 8 million more than with the creditable variant, at EUR 130 million thus EUR 34 million instead of EUR 26 million. With a cap, the payment reaches EUR 30 million at proceeds of EUR 110 million (EUR 10 million plus 20% of EUR 100 million). There it stays until the percentage also yields EUR 30 million at EUR 150 million. A twofold creditable preference would have secured EUR 20 million for the investor at proceeds of EUR 30 million and left EUR 10 million for the other shareholders.

For the founders this means: below the post-money valuation of EUR 50 million, the design of the preference decides over amounts in the millions. At high proceeds, only the non-creditable variant without a cap still matters.

Distinctions: liquidation preference, anti-dilution protection and subordination

• Anti-dilution protection: protects against later rounds at a lower price per share and concerns the percentage, not the order of distribution.
• Subordination of shareholder loans: a statutory ranking of claims in insolvency (Section 39(1) No. 5 of the German Insolvency Code, InsO). The preference, by contrast, governs only the relationship of the shareholders among themselves.

Common mistakes

• Valuation negotiated without the preference. A valuation premium in exchange for a non-creditable or multiple preference can be less favourable for founders in medium scenarios than a lower valuation with a simple creditable preference.
• Only the current round considered. What matters is the sum of all preferences, measured against realistically achievable sale prices.
• Ranking left open. Without an express rule on the relationship of the series, it is disputed with scarce proceeds who is served first.
• Preference amount defined unclearly. Convertible loans are usually converted into shares at a discount to the round price. It must therefore be specified whether the loan amount or the value of the shares received at the round price counts as the preference amount; the second solution raises the priority above the capital deployed.
• Articles of association and shareholders' agreement not aligned. If the preference appears only in the shareholders' agreement, distributions and liquidation proceeds may not be covered.
• Silent surcharges overlooked. Interest or cumulated preferred dividends let the priority grow over the years without renegotiation.

Frequently asked questions

Which liquidation preference is common in Germany?

The simple creditable preference (1x non-participating), especially in rounds from Series A. Multiple and non-creditable preferences occur mainly in difficult financing phases and at companies that have to raise capital under time pressure.

What is a negative liquidation preference?

A structure for employee participation (hurdle shares), in which the new shares participate only in proceeds above a set threshold. The threshold usually corresponds to the company value at issue; the proceeds up to that point go first to the existing shareholders. Because this reduces the value of the new shares, no benefit in kind arises on acquisition at this reduced value. The Bavarian tax administration confirmed this in 2026.

How is a liquidation preference treated for tax purposes?

Each shareholder is taxed on the proceeds it actually receives under the agreed distribution; a preference validly agreed in advance is generally also recognised for tax purposes. Private shareholders with a holding of 1% or more are taxed under Section 17 of the German Income Tax Act (EStG) under the partial income method (60% taxable), below that with final withholding tax. If a corporation holds the shares, 95% is tax-exempt under Section 8b of the German Corporation Tax Act (KStG).

Does the liquidation preference also apply in insolvency?

Practically not. Creditors are satisfied first, shareholder loans only on a subordinated basis. Any surplus is distributed as it would be due to the shareholders in a winding up outside the proceedings (Section 199 sentence 2 InsO), that is, under statute and articles of association.

Do founders receive anything in a sale below the sum of all preferences?

Not without a special agreement. The proceeds then flow entirely into the preferences, with a tiered ranking generally first to the most recent round. In this situation part of the proceeds is sometimes reserved in advance for management and key persons (management carve-out) to secure their cooperation in the sale.

The Roemer Capital view

Before a term sheet is signed, Roemer Capital calculates the distribution of proceeds for a range of sale prices. This expressly includes the range between the sum of all preferences and the post-money valuation of the new round. In this range it becomes clear what a valuation premium in exchange for a stronger preference is actually worth for founders and team.

In a sale process, Roemer Capital reconciles the preference rules from the articles of association and shareholders' agreement with the purchase price mechanism, so that purchase price distribution and payment schedule reflect the same ranking. The legal drafting rests with the client's law firm; Roemer Capital supplies the economic calculation and brings it into the negotiation.