When startups and investors come together to fuel innovation and growth, the shareholders’ agreement (“SHA”) becomes one of the most important legal documents governing their relationship. It is more than just a contractual formality, it is the framework that defines how a company is owned, managed, and funded, and how value is eventually distributed. Among the many critical clauses found in an SHA, two stand out for their potential to shape the financial outcomes for founders, investors, and other stakeholders i.e. liquidation preference and anti-dilution protection.
Understanding Liquidation Preference
One of the most significant protections for investors in an SHA is the liquidation preference clause. This provision dictates the order in which proceeds are distributed in the event of a liquidation, which can include not only the winding up of the company, but also a merger, acquisition, or sale of substantially all of the company’s assets. The purpose of liquidation preference is to ensure that investors, typically those holding preferred shares, recover their investment (and sometimes more) before any proceeds are distributed to common shareholders, who usually include the founders and employees and other minor individual investors.
This blog is a part of our The Essential Guide to Shareholders’ Agreements: Protecting Interests and Ensuring Smooth Governance of Companies blogpost.
Types of Liquidation Preferences
There are several types of liquidation preferences. A 1x non-participating preference means that investors get back their initial investment amount before others receive anything, but they do not participate in the remaining proceeds. In contrast, a 1x participating preference allows investors to first recover their investment and then share in the remaining proceeds alongside common shareholders, effectively giving them a double benefit. In some cases, investors negotiate for multiple preferences, such as 2x or 3x, meaning they receive two or three times their original investment before any proceeds are distributed to others. While such clauses are attractive to investors, they can significantly dilute the returns for founders, especially in lower-value exits where the liquidation stack consumes most of the sale proceeds.
Exploring Anti-Dilution Protection
Equally critical to understand is the concept of anti-dilution protection, which comes into play when the company issues new shares at a price lower than that paid by earlier investors, a scenario known as a “down round.” Anti-dilution provisions are designed to protect early investors from having their ownership and economic rights diminished by such events. Without this protection, an investor who paid $10 per share in an earlier round might see their effective value fall if the company later sells shares at $5 each.
Types of Anti-Dilution Provisions
There are two main types of anti-dilution provisions. The full ratchet mechanism is the more aggressive of the two. It adjusts the price per share of the earlier investor to match the lower price of the new round, regardless of the number of new shares issued. While it provides maximum protection to the investor, it can be very dilutive to the founders and may discourage future investment. The weighted average method, on the other hand, takes into account both the lower price and the number of shares issued, resulting in a more balanced adjustment. It is generally considered fairer and more startup-friendly, as it protects early investors while maintaining reasonable equity incentives for founders and employees.
Balancing Interests: Founders and Investors
Understanding and negotiating these provisions requires a careful balance. For founders, accepting aggressive liquidation preferences or anti-dilution terms can lead to unintended consequences, such as loss of control or significantly reduced payouts in the event of a sale. For investors, reasonable protections are essential to justify the risk of investing in an unproven venture. Therefore, both sides must approach these clauses with transparency and long-term alignment in mind.
Final Thoughts
In conclusion, liquidation preference and anti-dilution protection are not just legal technicalities but they are strategic financial tools that influence investor behaviour, founder incentives, and the ultimate success of the business. They should be carefully reviewed and negotiated in any shareholders’ agreement to ensure fairness, clarity, and sustainability. Whether you are an entrepreneur raising capital or an investor funding a startup, understanding these terms and their implications can make a substantial difference in your financial outcome.
For those navigating the complexities of a shareholders’ agreement, seeking expert legal advice can be invaluable. A detailed, clause-by-clause review not only protects your current interests but also sets a strong foundation for future growth and exit opportunities.
