Liquidation preference: how the clause works and how it applies in Brazil

A liquidation preference determines who gets paid first, and how much, when one of the events defined in the investment documents occurs, usually the sale of the startup. Depending on the multiple, participation in the remaining proceeds and the preferences of other rounds, a sale that looks good on paper can leave the founders with little or nothing. In Brazil, the clause usually starts life in a convertible loan agreement (mútuo conversível), and getting it right means distinguishing a sale of equity from the liquidation of the company and coordinating the investment contract with the corporate documents.

Sale of equity, sale of assets and liquidation

The phrase “sale of the company” covers three different situations. In a sale of shares or quotas, the buyer pays the selling shareholders, and the preference is a rule for splitting that price among them. In a sale of assets, the money goes into the company’s own accounts, and getting it to the shareholders requires a separate legal basis. In a liquidation, the company pays its creditors first and only then distributes what is left (articles 214 and 215 of Law No. 6,404/1976, the Brazilian Corporations Law). In none of these cases does a preference among shareholders rank ahead of the company’s creditors: it only governs how the shareholders divide what reaches them.

The multiple and participation

“Liquidation preference” is often read as a single term. In practice it has two components: the multiple, and whether or not the investor participates in the remaining proceeds.

The first is the multiple: the amount the investor receives ahead of the other shareholders, calculated on a base defined in the contract, usually the amount invested. In Venture Deals (4th ed., e-book, pp. 54-55), Brad Feld and Jason Mendelson note that 1x, meaning the money back, is the standard, and that higher multiples show up in later-stage or distressed financings.

The second is participation: the right, after receiving the preference, to share in what is left like any other shareholder. With participating preferred, the investor receives the preference amount and then also takes part in the split of the remainder.

The same authors describe three varieties: no participation (non-participating), full participation and capped participation, in which the amount the investor can receive under the participating preference is subject to a ceiling.

The numbers

Suppose an investor puts in R$ 10 million for 25% of the company, and that the figures below are what reaches the shareholders after debt, expenses and other deal adjustments. With a non-participating preference, if the documents provide for conversion, as they usually do, the investor can give up the preference and convert its preferred shares into common shares, taking its percentage instead. It picks whichever pays more.

Sale for R$ 40 million

With 1x non-participating, the investor chooses between a R$ 10 million preference and converting to take 25%, which comes to the same R$ 10 million. The founders keep R$ 30 million. With 2x non-participating, the investor takes R$ 20 million, leaving another R$ 20 million. With 1x participating, it takes R$ 10 million plus 25% of the remaining R$ 30 million, R$ 17.5 million in total.

Sale for R$ 200 million

With 1x non-participating, the investor converts and takes R$ 50 million. With 2x non-participating, it also converts, because the R$ 20 million preference pays less, and ends up with the same R$ 50 million. With 1x participating, it takes R$ 10 million plus 25% of the remaining R$ 190 million, or R$ 57.5 million. With participation capped at 3x, the participating preference would pay at most R$ 30 million; conversion pays more, so the investor converts and ends up with the same R$ 50 million.

Participating preferred gives the investor an extra amount that is close to fixed: the preference less the part of it the investor would have received anyway as a shareholder, R$ 7.5 million in both sales in the example. That is why it matters less and less as the price rises. When the amount available does not cover the capital invested, even a 1x preference takes everything; a higher multiple makes a difference in the next band up, where there is money above the 1x preference. Comparing 1x participating with 2x non-participating, both send the entire amount to the investor when up to R$ 10 million is available. Above that and below R$ 50 million, 2x non-participating costs the founders more. At R$ 50 million the two are level again; above that point, uncapped 1x participating costs more.

The effect compounds with each round. In a company that has raised R$ 80 million over three rounds with 1x preferences, any sale below that figure will tend to go entirely to the investors. This is known as preference overhang.

Seniority: stacked or pari passu

When there is more than one round, the parties need to settle seniority, meaning which investors get paid first among themselves. With a senior (stacked) preference, the rounds are paid in an order set in the negotiation; one possible design is for the latest round to be paid first and the earlier round only if anything is left. With a pari passu preference, the rounds share the proceeds in proportion to the preference owed to each, which can differ from the amounts invested when the multiples vary.

The order of payment stops affecting the amounts received once there is enough to satisfy every preference, all other terms being equal. Below that point, it decides who gets paid. It also shapes the dynamics among investors: when the latest round is senior, its investor may have an incentive to accept a sale the earlier investors would turn down.

Where the clause usually sits: the convertible loan agreement

In early rounds, startup investment in Brazil is commonly made through a convertible loan agreement (mútuo conversível), the local counterpart of a convertible note: the investor lends money to the company and gets the right to convert that debt into equity later. The Brazilian Startup Legal Framework (Complementary Law No. 182/2021) recognises the instrument (article 5, paragraph 1, IV) and provides that the investor becomes a quotaholder or shareholder only after conversion (article 5, paragraph 2). Until then, the investor is neither and is not liable for the company’s debts, except in cases of wilful misconduct, fraud or sham arrangements involving the investor (article 8).

That is why the liquidation preference is often found in the loan agreement itself. A common formulation provides that, if a liquidity event occurs before conversion, the investor chooses between being repaid the amount invested, sometimes with a multiple, and converting to receive its share of the price. Depending on the structure, the obligation may rest with the company or with the founders, or take the form of a rule for splitting the price received by the sellers. In principle, the limits in article 109, II, of the Corporations Law and article 1,008 of the Civil Code, discussed below, do not apply, because the investor is not yet a shareholder.

The difficulty lies in conversion. A preference set out in the loan agreement does not automatically become a corporate right. Implementing it must be coordinated with the bylaws (estatuto social) or the articles of association (contrato social), where it involves rights attached to a class of shares or quotas (in an S.A., on the basis of article 17, II, of the Corporations Law), and with the contractual instruments that govern how the sellers split the price. Obligations undertaken in the loan agreement, including by the founders, may survive conversion, depending on how the survival clauses are drafted. Without that care, the investor may come out of the conversion with less protection than it had as a creditor.

Protection is built into the loan agreement itself, before conversion. One solution is to attach to the agreement the draft shareholders’ or quotaholders’ agreement that will apply after conversion, already setting out the multiple, participation, seniority and waterfall, and to make the founders parties, bound to vote for the necessary corporate changes. It is also advisable to state expressly that the founders’ obligation to follow the waterfall when selling their equity survives conversion. Another option is for the investor to convert only at the liquidity event, once the rule for splitting the price has been signed by everyone.

For the founder, conversion is the moment to check that the preference implemented in the corporate and contractual documents is the one negotiated in the loan agreement, with no higher multiple and no participation that was not there before, and that the investor cannot be paid twice, as a creditor and as a shareholder.

In a corporation (S.A.), the law already provides for priority

If the investor converts and the company is a sociedade anônima (S.A.), the Brazilian corporation, the preference can be written into the bylaws. Article 17, II, of the Corporations Law provides that the advantages of preferred shares may consist of “priority in the reimbursement of capital, with or without a premium” (our translation). This is the legal basis for the preference, in place in Brazil since 1976. Implementation depends on the bylaws, which must define the base for reimbursement (amount invested, issue price, inflation adjustment) and the premium. Nor does the statute, on its own, settle how the price is split in a sale of equity.

Article 19 requires the bylaws to state the advantages of each class of shares. For the preference to be an advantage of the preferred shares, it must be in the bylaws; a shareholders’ agreement is not enough. The contractual split of the price among the sellers, by contrast, can sit in the shareholders’ agreement.

The limit lies in article 109, II: neither the bylaws nor the general meeting may deprive a shareholder of the right to share in the remaining assets in a liquidation. That does not guarantee that every shareholder receives something in every scenario. Receiving nothing because the assets ran out after valid preferences were paid is not the same as having the right taken away.

Moreover, a sale of equity involves no liquidation: what is split is the price the buyer pays the sellers. That split is contractual, supported by the shareholders’ agreement (article 118 of the Corporations Law) and by article 421-A of the Civil Code, which presumes business contracts to be negotiated on an equal and symmetrical footing and requires the parties’ allocation of risk to be respected. For that reason, in our view, article 109, II, reaches less far than it seems.

In practice, a clause drafted as a rule for distributing the sale price (a waterfall) is easier to defend than one that tries to operate as an advantage under the bylaws in a situation that is not a liquidation.

In a limited liability company (Ltda.), there is more uncertainty

A limitada has no shares, and it is the form many Brazilian startups still have when they take their first cheque, usually through a convertible loan. After conversion, the preference can sit in the quotaholders’ agreement and also in the articles of association: rules issued by DREI, the federal business registration authority, allow classes of quotas with distinct economic and political rights, defined in the articles, where the company is governed on a supplementary basis by the Corporations Law (DREI Normative Instruction No. 81/2020, as currently in force). The scope of those advantages is still debated.

Article 1,007 of the Civil Code allows quotaholders to agree on a split of results that departs from their quota holdings. Article 1,008 sets the limit: any clause excluding a quotaholder from sharing in profits and losses is void. Two arguments weigh in favour of the preference: a disproportionate split is not the same as excluding a quotaholder, and the price paid in a sale of quotas is not profit distributed by the company.

The arguments are defensible, but this is where most of the doubt lies. Transforming the company into an S.A. is an option to weigh before the loan converts, taking into account the rights sought, governance, costs and future rounds. The Startup Legal Framework simplified the privately held S.A.: it allowed a single-member executive board and reduced publication requirements for privately held companies with annual gross revenue of up to R$ 78 million (articles 143 and 294 of the Corporations Law).

Unjust enrichment and “double dipping”

Unjust enrichment (article 884 of the Civil Code) requires a gain without legal justification, and a preference negotiated in exchange for the investment has one, although that does not end the analysis of validity. Combining the preference with participation in the remaining proceeds is often called “double dipping” in venture capital. The term describes the economic structure; it does not, by itself, establish that the investor is receiving an unlawful duplicate payment. What can open a dispute is a defect in how the contract was formed, and it has to be proven: lack of legal advice, a contract drafted in English or a poor economic outcome do not, on their own, establish mistake or fraud (articles 138 and 145) or an adhesion contract (article 423). In business contracts, parity is presumed (article 421-A), and the analysis also turns on objective good faith (article 422).

Is there case law?

In a public search carried out in September 2026, we did not identify any Brazilian court decision directly addressing the validity of a liquidation preference clause. That does not mean such decisions do not exist.

One possible explanation is the frequent use of arbitration in these contracts, often with confidentiality provided for in the arbitration agreement or in the institution’s rules.

Practical steps

• Ask two questions: what is the multiple, and is there participation? A term sheet that says only “1x liquidation preference” has not answered the second.
• Ask for a waterfall analysis under three scenarios, always including a sale below the total capital invested to date. That is the scenario in which the clause decides everything.
• Look at the multiple, participation, cap and seniority together. A cap on participating preferred, for instance, can solve part of the problem without touching the multiple.
• Check whether preferences are stacked or pari passu, and what that does to earlier rounds.
• With a convertible loan, check how the preference will be implemented on conversion: the draft agreement attached, the founders’ obligations and the survival clause.
• Negotiate a management carve-out, a portion of the proceeds reserved for the team even when the preferences would absorb everything else.
• Remember that seed terms become the reference for later rounds. Participating preferred accepted in the first round tends to reappear in every round that follows.

Frequently asked questions

What is a liquidation preference, in one sentence?

It is the investor’s right to receive a defined amount ahead of the other shareholders in certain events set out in the investment documents, such as the sale of the company, usually calculated as a multiple of the amount invested.

Is 1x participating better or worse than 2x non-participating?

It depends on the amount that reaches the shareholders. In this note’s example, both send everything to the investor up to R$ 10 million; between R$ 10 million and R$ 50 million, 2x non-participating costs the founders more; at R$ 50 million they are level, and above that uncapped 1x participating costs more. The answer comes from modelling a few scenarios.

Is the clause valid in Brazil?

A liquidation preference can be validly structured under Brazilian law, but its validity and effect depend on its terms and how it is implemented. In an S.A., article 17, II, of the Corporations Law allows priority in the reimbursement of capital, with or without a premium, provided the bylaws define it. Participation in the remaining proceeds and high multiples rest on freedom of contract between parties on an equal footing. Under a convertible loan, before conversion, the preference is a contractual obligation.

What happens to the preference when the convertible loan converts?

A preference in the loan agreement does not automatically become a corporate right. It must be implemented in the bylaws or articles of association, where it involves rights attached to a class of shares or quotas, and in the instruments that govern how the sellers split the price. Obligations under the loan agreement may survive conversion, depending on how they are drafted.

Does an IPO trigger the liquidation preference?

Not automatically. The investment documents may provide for the preference to fall away, or for preferred shares to convert into common shares, on an IPO, subject to the conditions they set (the Corporations Law deals with conversion in article 19). Both the definition of the events that trigger the preference and the conversion rules need to be checked.

Points to watch when structuring

How robust each arrangement is depends on the design of the clause, the type of company (Ltda. or S.A.), how the loan agreement handles conversion and the record of the negotiation.