Non-Participating Liquidation Preference

What is a non-participating liquidation preference?

Non-participating liquidation preference (German: anrechenbare or nicht teilnehmende Liquidationspräferenz) is a form of liquidation preference under which an investor receives the higher of two amounts on an exit. An exit means the sale of the company or an event treated as equivalent by contract. Either the investor receives its preference amount, usually the capital invested, or its pro rata share of total proceeds, that is, the share corresponding to its shareholding. It is comparable to two envelopes, one containing the stake and one the share of proceeds: the investor receives the fuller one, never both. The clause is also abbreviated to non-participating liq pref.

The clause is agreed in the term sheet, the letter of intent setting out the key terms of the round, and is implemented in the proceeds distribution rules of the shareholders' agreement and articles of association. The simple form, in which the preference amount equals the capital invested (1x non-participating), is customary in German funding rounds. For the investor, it is protection against sales below its entry price; for founders and existing shareholders, a limit on this priority. It affects employees with virtual shares because in mid-range sale scenarios it helps determine the size of their payout.

Formula: payment to the investor = maximum (preference amount; shareholding × distributable proceeds), at most the distributable proceeds

The choice between preference and pro rata share

In the US market, the mechanism is structured as an option. Holders of preferred stock, the investors' preferred shares, decide on an exit: they claim the preference amount or convert their shares into ordinary shares (common stock) and participate pro rata. In a German GmbH (limited liability company), no shares are converted. The choice is built into the proceeds distribution clause as a calculation rule, usually in one of two formulations:

• Maximum amount rule: The investor receives the higher of the preference amount and the pro rata share of total proceeds.
• Offset rule: The investor first receives the preference amount. Then the other shareholders receive in advance as much as is needed until they have caught up in proportion to their shareholdings, and only the remainder is distributed to all pro rata.

With a single preference, both formulations lead to the same result. A declaration by the investor is usually not needed; the distribution follows from the proceeds. If the calculation favours the pro rata share, the investor retains all its other rights under the articles of association and shareholders' agreement, such as veto rights (consent requirements for certain resolutions), information rights and tag-along rights. The pro rata share concerns only the distribution of the specific proceeds; the investor is thereby neither placed on an equal legal footing with the founders nor does it lose its special rights.

Calculating the conversion threshold

The conversion threshold is the level of proceeds above which the pro rata share exceeds the preference amount. The name comes from the US market, where the investor converts into common stock at this point; in the GmbH, it merely denotes the tipping point of the calculation.

Formula: conversion threshold = preference amount divided by shareholding

With a simple preference, the shareholding at entry corresponds to the ratio of investment amount to post-money valuation. The threshold is therefore exactly at the post-money valuation of the round: if the distributable proceeds reach at least this value, the preference has no effect.

Two factors shift the threshold upwards. A multiplier raises it in the same proportion: with a 1.5x preference, it is at 1.5 times the post-money valuation, with a 2x preference (2x non-participating) at twice that. Later funding rounds dilute the shareholding, so that the threshold rises although the preference amount stays the same. It must therefore be recalculated after every round.

The indifference range

Between the preference amount and the conversion threshold, the investor receives a fixed amount, regardless of the price achieved. In this range, every additional euro flows entirely to the other shareholders. In a higher purchase price, the investor has no economic stake there, but it does in a secure completion. This alignment of interests must be taken into account when shareholders coordinate a sale process, for example on the question whether to accept an early offer or continue a competitive bidding process.

Several series

If several rounds hold non-participating preferences, their thresholds depend on each other. If one series takes its preference amount, it drops out of the pro rata distribution; the remaining proceeds are distributed among the other shares, and the calculation of every other series changes. The thresholds can therefore be determined only in the context of all preferences. A waterfall analysis does this, working through the decisions of the series step by step.

The non-participating clause in the contract

Whether the clause works as intended on an exit depends less on its label than on its definitions. In negotiation, four points above all must be settled:

• Reference base of the shareholding: whether the pro rata share is based on the shares issued or on a fully diluted basis, including virtual shares and promised options (fully diluted).
• Definition of proceeds: whether the comparison is made on the basis of the purchase price or of the proceeds after transaction costs, debt and payments under employee programmes.
• Later purchase price components: how earn-out payments and escrow retentions are treated. A cumulative recalculation with each payment is customary, so that the comparison between preference and pro rata share can tip retrospectively.
• Interest: whether the preference amount bears interest. Interest increases the preference and with it the conversion threshold every year.

Worked example: 1x non-participating in Series A and Series B

An investor takes part in a Series A with EUR 5 million at a pre-money valuation of EUR 15 million. The post-money valuation is EUR 20 million, its shareholding 25%. A simple non-participating preference is agreed; in each case the proceeds after deduction of debt and transaction costs are what counts.

• Conversion threshold: EUR 5 million divided by 25% = EUR 20 million, exactly the post-money valuation.
• Proceeds of EUR 4 million: The proceeds do not cover the preference. The investor receives EUR 4 million, the other shareholders nothing.
• Proceeds of EUR 12 million: The pro rata share would give EUR 3 million. The investor receives the preference amount of EUR 5 million, the other shareholders EUR 7 million.
• Proceeds of EUR 20 million: Pro rata share and preference each give EUR 5 million. The other shareholders receive EUR 15 million, exactly their 75%.
• Proceeds of EUR 40 million: The pro rata share gives EUR 10 million. The investor receives EUR 10 million, the other shareholders EUR 30 million.
• With a 1.5x preference, the preference is EUR 7.5 million and the threshold EUR 30 million. At proceeds of EUR 20 million, the investor would receive EUR 7.5 million, the other shareholders EUR 12.5 million.

Later, a second investor takes part in a Series B with EUR 10 million at a post-money valuation of EUR 50 million. It receives 20% and likewise a simple non-participating preference; the Series A shareholding falls to 20%. Viewed in isolation, its threshold would now be EUR 25 million (EUR 5 million divided by 20%). In fact it is higher: below EUR 50 million of proceeds, the Series B takes its preference of EUR 10 million and drops out of the pro rata distribution. Series A then holds 25% of the remaining shares (20 of 80 percentage points). Its threshold is EUR 10 million plus EUR 5 million divided by 25%, that is, EUR 30 million. The Series B itself switches to the pro rata share only from EUR 50 million (EUR 10 million divided by 20%).

For the founders, this means: after the Series A, they received their full pro rata share from EUR 20 million of proceeds; after the Series B, only from EUR 50 million. Between these values, at least one series takes its preference, and the founders receive less than their shareholding corresponds to.

Distinction: non-participating, participating and anti-dilution protection

• Participating liquidation preference: The investor receives the preference amount and in addition participates pro rata in the remaining proceeds (double dip). The non-participating variant rules out this double payout.
• Participating with a cap: a middle way in which the double participation extends up to a maximum amount. Once the cap is reached, it works like a non-participating preference in the amount of that cap.
• Anti-dilution protection: adjusts the investor's shareholding in later rounds at a lower price and thereby indirectly changes the pro rata share against which the preference amount is compared.

Common mistakes

• Label checked instead of mechanics. Whether a preference is non-participating or participating follows from the distribution formula, not from the heading of the clause.
• Threshold calculated only at entry. After every further round, the threshold rises through dilution and through the preferences of the new investors.
• Interest overlooked. Annual interest on the preference amount or accrued preferred dividends increase the preference without any change in the label.
• Shareholding not defined. If there is no rule on whether virtual shares and options count towards the shareholding, the comparison between preference and pro rata share on an exit is prone to dispute.
• Consequences for other rights misjudged. If the calculation favours the pro rata share, the investor's consent requirements, information rights and tag-along rights remain unaffected.

Frequently asked questions

What does the investor receive if proceeds are below the preference amount?

All the distributable proceeds, provided there is no senior or pari passu preference of another round. The other shareholders receive nothing in this case. The preference does not give rise to a claim against the founders to make up the shortfall.

What does 1x non-participating liquidation preference mean?

On an exit, the investor receives first its invested capital, to the extent the proceeds suffice, or its pro rata share if that is higher. The "1x" stands for the multiplier: the preference amount equals one times the investment amount, without interest or premiums. With 2x it would be twice as much.

What is the difference between participating and non-participating liquidation preference?

With non-participating, the investor receives the preference or its pro rata share; with participating, both one after the other. An example: EUR 5 million preference, 25% shareholding, EUR 40 million of proceeds. With participating, EUR 13.75 million flows to the investor (EUR 5 million plus 25% of EUR 35 million), with non-participating EUR 10 million.

Must the investor declare on an exit whether it chooses preference or pro rata share?

In German contracts, usually not. The proceeds distribution clause is worded as a calculation rule that leads to the higher amount without a declaration. If a contract exceptionally provides for an express option, it also regulates the deadline and form of the declaration.

Does the preference end on an IPO?

As a rule yes. Before an IPO, the GmbH is converted into a stock corporation (Aktiengesellschaft), and investment agreements usually provide that the preferential rights lapse with the IPO. Some contracts link this to a minimum issue price or a minimum volume (qualified IPO).

Why do investors accept a preference without additional participation?

Because it limits the downside risk and secures the full pro rata share at high proceeds. Additional participation would put the investor ahead mainly in mid-range scenarios, in which founders and team receive less anyway. In practice, the non-participating form is therefore regarded as balanced.

The Roemer Capital view

In the funding rounds Roemer Capital supports, it calculates the conversion thresholds of all series before and after the new financing. Founders thus see from which level of proceeds the preferences no longer take effect and how far the new round raises this point. This figure says more than the label "1x non-participating" alone.

In sale processes, Roemer Capital uses the thresholds to make the shareholders' alignment of interests visible early, for example when an investor lies in the indifference range. The wording of the distribution clause is the responsibility of the client's law firm; Roemer Capital checks whether it reproduces arithmetically what was agreed economically.