IS A “LIQUIDATION PREFERENCE” CLAUSE THAT LEAVES FOUNDERS WITH NOTHING AFTER THE SALE OF THEIR COMPANY LEGALLY VALID?

In fundraising transactions, many founders focus primarily on the amount of capital raised and the company’s valuation while paying little attention to investor protection provisions. One of the contractual terms that can significantly affect a founder’s economic interests is the Liquidation Preference clause.

In practice, numerous founders who have spent years building and growing their businesses ultimately receive little or no financial return when their companies are sold because all or most of the transaction proceeds are distributed to investors in accordance with previously agreed contractual provisions. This raises an important legal question:

Is a Liquidation Preference clause legally enforceable? Can a founder request that such a clause be declared invalid?

Let us examine a real-world scenario with legal analysis from M.A. Nguyen Huu Long to identify a practical and legally sound solution.

1. Case Summary

An e-commerce startup received an investment of VND 20 billion from a venture capital fund in exchange for 20% equity ownership.

During the investment negotiations, the fund included a Liquidation Preference provision in the Investment Agreement, granting the investor the right to recover its entire investment, together with a predetermined return, before any remaining proceeds would be distributed to other shareholders if the company were sold, merged, or liquidated.

Because the founders were primarily focused on obtaining funding quickly to expand the business, they signed the agreement without carefully reviewing this provision.

Three years later, the company received an acquisition offer from a foreign corporation at a price below expectations. Pursuant to the Investment Agreement, almost the entire purchase price was distributed to the investor under the Liquidation Preference clause. Despite having spent years developing the business, the founders received only a minimal portion of the sale proceeds.

Believing that the clause was excessively unfavorable, the founders questioned whether the Liquidation Preference provision was legally valid and whether it could be declared invalid.

1. Legal Perspective – A Solid Legal Shield
2. Applicable Laws

Under Article 3(2) of the 2015 Civil Code of Vietnam, individuals and legal entities are free to enter into agreements regarding the establishment, performance, or termination of civil rights and obligations, provided that such agreements do not violate mandatory legal provisions or social ethics.

According to Article 117 of the 2015 Civil Code, a civil transaction is legally valid only if it satisfies all statutory conditions relating to:

• Legal capacity of the parties;
• Voluntary consent;
• Lawful purpose and content; and
• Compliance with the legally required form.

Furthermore, under Article 127 of the 2015 Civil Code, a party that enters into a transaction due to fraud, coercion, or threats has the right to request the court to declare that transaction invalid.

In addition, Article 115(1) of the 2020 Law on Enterprises provides that ordinary shareholders exercise their rights in accordance with applicable laws and the company’s charter.

At present, the 2020 Law on Enterprises does not contain specific provisions governing Liquidation Preference clauses. Therefore, the legality of such provisions is primarily determined based on:

• The principle of freedom of contract under the Civil Code; and
• The agreements reached by the parties in the Investment Agreement, Shareholders’ Agreement, or the Company’s Charter.

2. Legal Analysis of the Case

In this case, the founders voluntarily signed the Investment Agreement containing the Liquidation Preference provision.

The existence of such a clause does not automatically render it unlawful.

If the founders entered into the agreement voluntarily, possessed full legal capacity, and the clause did not violate any mandatory provisions of law, the Liquidation Preference clause is generally enforceable, and the parties are required to honor their contractual commitments.

Conversely, if the founders can demonstrate that their consent was obtained through fraud, coercion, intimidation, or if the clause fails to satisfy the validity requirements prescribed under Articles 117 and 127 of the 2015 Civil Code, they may petition the court to declare either the entire transaction or the relevant contractual provision invalid in accordance with Vietnamese law.

3. Legal Conclusion

A Liquidation Preference clause is not prohibited under Vietnamese law.

Its legality depends upon:

• The parties’ genuine and voluntary consent;
• The contents of the agreement; and
• Compliance with the legal requirements governing the validity of civil transactions.

Accordingly, founders should exercise particular caution when negotiating liquidation preference provisions in order to avoid losing a substantial portion of the value they have created when the company is sold or exits through another liquidity event.

III. Psychological, Educational, and Corporate Governance Perspectives – The Human-Centered Approach

Legal Perspective

Liquidation Preference is a widely accepted mechanism in venture capital transactions designed to protect investors against investment risks.

However, if drafted in an excessively investor-friendly manner, it may create an imbalance between investors and founders and become a significant source of future disputes.

Psychological and Educational Perspective

Many founders focus solely on obtaining investment capital while overlooking the legal implications of contractual provisions.

Only after the company becomes successful or is acquired do they realize that their own financial interests have been substantially reduced.

Developing a solid understanding of legal terms before raising capital is therefore essential to protecting the long-term interests of founders.

Corporate Governance Perspective

Startups should establish a comprehensive legal review process for every investment agreement, especially provisions concerning:

• Liquidation Preference;
• Anti-Dilution;
• Drag-Along Rights;
• Tag-Along Rights; and
• Veto Rights.

Obtaining legal advice before signing investment documents enables founders to identify potential risks and negotiate more balanced contractual terms.

1. Comprehensive Solutions Recommended by Expert Nguyen Huu Long

Step 1

Carefully review and analyze every provision of the Investment Agreement, particularly those governing the allocation of proceeds upon the sale, merger, or liquidation of the company.

Step 2

Actively negotiate a reasonable liquidation preference by limiting its scope and assessing its impact on the rights and interests of founders and existing shareholders.

Step 3

Consult experienced legal counsel before executing fundraising documents to ensure that contractual provisions comply with applicable laws and do not expose the company to unnecessary future risks.

Expert Opinion

According to Nguyen Huu Long, Liquidation Preference is not an unlawful contractual provision; rather, it is a mechanism for allocating risk between investors and founders.

The real issue is not whether such a clause exists, but whether the parties negotiate it in a manner that fairly balances their respective interests.

A professional founder is not only capable of successfully raising capital but also understands the legal implications of every contractual provision before signing.

Expert’s Message

In investment transactions, the amount of money received today is less important than the rights you retain tomorrow.

Before signing any agreement, founders should fully understand every contractual provision, because a single overlooked commitment may result in years of hard work yielding little or no financial reward.

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