[Direct answer]In the Beijing area, when a company is liquidated, sold, or undergoes a change of control, preferred shareholders are given priority to recover their investments before ordinary shareholders, and then decide whether to participate in the remaining distribution. There are three core parameters: the preferred multiple (commonly one, or more aggressively 1.5 to two times), whether to participate in the distribution (participatory types can first receive the preferred amount and then divide the remaining amount proportionally, while non-participatory types choose one of the two options), and the participation cap (participatory types are usually capped at a return of two to three times). When making such agreements, they must be coordinated with the definition of liquidation events, clauses deemed equivalent to liquidation, and founder compensation mechanisms. It's important to ensure that these clauses aren't just theoretical statements.

I. Problem Background and Typical Scenarios

The company was sold at a valuation of $100 million, but the investors only invested $20 million that year. According to the liquidation preference, they would first recover their principal and even receive a multiple return, leaving very little for the founding team—the liquidation preference is the most important factor in the distribution of assets during a merger or acquisition exit. Many founders only realize the true meaning of the terms on the day of settlement.

II. Key points of contention

First, the definition of liquidation events: the scope of statutory liquidation, overall sale, and deemed liquidation. Second, the selection of priority multiples and participation models. Third, the ranking of investors in each round. Fourth, the connection with the order of asset distribution in corporate law during liquidation.

III. Professional analysis by Henglue Lawyers

Based on Henglue Lawyer's experience in handling financing agreements, the design of liquidation priority rights should focus on four aspects: 1. **Event Definition**: Beyond statutory liquidation and dissolution, consider selling the company's control rights, major assets, or mergers as liquidation events (equivalent to liquidation clauses), ensuring that priority rights are triggered during M&A exits. Neglecting these liquidation clauses is a common mistake, often leading to lost priority rights when selling the company. 2. **Parameter Design**: Start with a priority multiple of 1x. Higher multiples reduce founders' residual rights. Participation clauses (investors participate proportionally after exhausting priority amounts) favor investors but squeeze founders. Founders should strive for non-participation clauses (one-or-the-other option) or set participation caps. An intermediate solution is capping participation at 2x or 3x total returns. 3. **Ranking Arrangement**: For multiple financing rounds, later rounds typically take precedence over earlier ones (first-come, first-served) or share priority amounts proportionally. Ranking arrangements directly affect actual distributions during M&A, so agreements must clarify each round's priority. 4. **Legal Integration**: Company law prescribes statutory order for liquidation asset distribution (liquidation costs, employee salaries/social insurance, taxes, ordinary creditors, then shareholders' contributions). Investment agreements should ensure priority arrangements through all shareholders' consensus, without harming creditors' interests. Enforcement should be secured by both bylaws and shareholder agreements to avoid agreements remaining mere intentions without bylaws to back them. From the founder's perspective, negotiation checklists include: - Non-participation priority of 1x - Priority amounts limited to investment principal - Liquidation equivalence requiring board or majority shareholder approval - Retention of veto rights against low-price sales Liquidation priority rights govern distributions in failure and exit scenarios. Every percentage point agreed upon during contract signing will materialize at the M&A negotiation table.

IV. Practical suggestions and legal basis

The first step is to define liquidation events and situations deemed equivalent to liquidation, covering both overall sales and mergers. The second step is to determine the priority multiple, participation model, and participation cap, confirming these through multiple rounds of sequential arrangements and diagrams. The third step is to solidify clauses in the shareholders' agreement and company bylaws, clarifying the execution process. The fourth step is to simulate the distribution of assets among all parties according to the clauses before the merger and acquisition closing, using this as the base price for sales negotiations. Main legal basis: - The Company Law of the People's Republic of China (amended on December 29, 2023 and effective from July 1, 2024) regarding the order of company liquidation and distribution of remaining assets; - Article 501 of the Civil Code of the People's Republic of China (effective since January 1, 2021) on supplementary rules for contracts; - Specific applications shall be subject to the currently effective provisions.

5. Henglue Law Firm's Reminder

Three key points regarding liquidation preference: First, define the event and then discuss the multiplier. It's crucial not to overlook liquidation clauses. Second, the participation model and cap are the main negotiation points for founders. A reasonable starting point is a one-for-one participation ratio. Third, both the agreement and the bylaws should be clearly defined, and a simulated distribution should be conducted before a merger or acquisition. For questions regarding the design of financing clauses, please feel free to consult us.Business and contract disputes in enterprisesWe provide a comprehensive solution for services, which can be integrated into mergers and acquisitions and exit transactions.Company and commercial disputesFor more information on the liquidation and dissolution procedures, please refer to the relevant sections.Special servicesFor columns related to disputes over shareholder agreements, you can seek advice from usContract disputesTeam.

VI. Frequently Asked Questions

Q1: What's the difference between fully participatory and non-participatory learning methods?

Non-participatory investors can choose between getting their principal back first and receiving a proportional share of the distribution; participatory investors get their principal back first and then participate in the remaining distribution on a proportional basis, benefiting from both ends. When exiting at a high valuation, the participatory model significantly squeezes the founders, which is the core point of negotiation and disagreement.

Q2: Is the liquidation preference effective in the event of a real liquidation?

The priority arrangement among shareholders is realized through the shareholders' agreement in the legal liquidation of the company, but it cannot conflict with the statutory repayment order and the interests of creditors. If the company is insolvent and enters liquidation, the actual recovery rate of the investors' priority rights depends on the company's ability to repay debts.

Q3: Is the acquisition of a company considered liquidation?

What's not stipulated in the agreement doesn't count, and the priority right may be lost. Therefore, it's necessary to include provisions regarding liquidation, such as the sale of control rights, major assets, and mergers, into the triggering scope. This is a prerequisite for the priority right to be exercised upon the exit of the merger and acquisition.

Q4: How are the priority rankings arranged after multiple rounds of financing?

It's common for the rear wheels to take priority over the front wheels (last in, first out), and each wheel also shares the priority amount in proportion to the investment amount. The order of priority determines who gets the money first when selling at a low price, and the agreement and settlement documents need to be consistent across all rounds.

Q5: Can the founder negotiate away the liquidation preference right?

The terms can be negotiated to be more favorable: not participating in the first round, limiting the principal amount, and setting a veto right for low-price sales are all common concessions. However, it's difficult to completely remove the priority right, as investors view it as the core of the risk-reward ratio.

The above answer is based on the judicial practice in Beijing. The adjudication guidelines in other provinces and cities may vary. For specific cases, please refer to the local rules and evidence situation.

If you are currently facing similar problems, it is recommended that you consult a professional lawyer as soon as possible with the relevant evidence materials, to avoid missing the statutory time limits. →Business and commercial legal services·Beijing Henglu Law Firm

Disclaimer: This article is compiled based on the current effective laws and regulations and public adjudication rules, and is for general reference only. It does not constitute a formal legal opinion on specific cases. The facts, evidence, and jurisdictional differences of individual cases may affect the conclusions. In case of disputes, please consult a practicing lawyer in time.