Rules of the Road: liquidation preferences in China and Asia

With nearly two decades of technology investment experience, I’ve seen a lot of deals—and I’ve found that the investment terms in Asia, especially China, are the least entrepreneur-friendly in the world.

Surprisingly, Singapore and Hong Kong can at times be worse than mainland China, since investors in these markets have little early stage investment experience. And because they are coming from a private equity background where capital preservation is almost as important as capital appreciation, they include many investor “protections” in their deal documents.

To be fair, venture capitalists in China have traditionally had reason to be less friendly, because entrepreneurs in China have been known to do some unsavory things to their investors, relying in part on the weaker legal system of the country.

However, while the market has matured and trust grown over the last few years, prevailing investment terms haven’t changed that much.

Rules of the Road is here to help you understand venture capital or VC terms, including current market standard practice, so that after you outdrive the competition to the finish line, you don’t get run over by your own investors.

There are many articles and blogs out there about VC terms, but most of those resources focus on the U.S. market rather than Asia in general or China in specific. We hope to give a sense of what is “normal” on this side of the Pacific.

Liquidation preference

Liquidation preference is a common term that VCs use to ensure they receive a certain amount of money before other shareholders when there is a liquidation event such as a sale of the company.

This term helps to motivate a founder to push for a sale of the company that will give the investor back its capital plus a profit. Without a liquidation preference, a founder who owns a large percentage of the company could have a life changing exit by selling at a valuation that would result in a loss to the VC.

In the U.S., it’s common to see a “straight preferred” or “non-participating preferred” liquidation preference of 1.0x, where at time of exit the VC would at minimum receive 1.0x their invested money back before common shareholders receive anything.

If, however, the exit is at a valuation that exceeds the post money valuation the VC invested at, then the VC would just receive a percentage of the exit amount equal to its percentage ownership of the company.

For example, say the VC purchased 20% of the company for a US$1m investment, and the company is sold for US$10m: the investor would receive 20% of the US$10m, or US$2m. The VC owns 20% of the company and they receive 20% of the return. This “non-participating preferred” is therefore downside protection for the VC, but it does not give them a better investment return if there is a big exit.

In China and Asia, it is fairly standard to see a 1.5x liquidation preference that is“participating preferred”, which means the VC would first receive 1.5x their invested money back at exit, and the remaining cash would be split based on each holder’s percentage ownership of the company.

For example, say the VC owns 20% of the company for a US$1m investment and the company is sold for US$10m: the investor would receive US$1.5m first and then receive another 20% of the remaining US$8.5m (i.e. US$1.7m) for a total of US$3.2m of the US$10m exit proceeds. The VC owned 20% of the company, but they receive 32% of the exit proceeds.

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