New businesses, and especially startups, can be risky for financial investments. Of course, investments always involve risks, but the possibility of high profits, particularly in the case of an IPO or M&A transactions, still attract investors. There are many tools, however, to mitigate the risks, and if the transaction papers are carefully drafted with respect to the investors’ interests, the potential losses can be minimized, even if a company fails to fulfill its promise.
In this article, we will analyze a mechanism known as “liquidation preference”, its types and components, on how best to protect investors.
First, let’s define what is liquidation. According to the Israeli Companies Law, “a company shall exist from the date of its incorporation as set out in its certificate of incorporation, until its incorporation is ended upon its dissolution”.
Therefore, liquidation is the process of terminating the existence of a company and distributing its assets among interested parties. However, the term “liquidation” when referring to a liquidation preference mechanism, usually controls the distribution of funds not only in a classic liquidation event, but also in mergers, acquisitions and assets sale transactions, events in which the shareholders or the company are expected to receive funds in return for the shareholders’ securities of the company’s assets. Such events are usually referred to as “deemed liquidation events”.
Liquidation or deemed liquidation may be voluntary (when shareholders make the decision to terminate their business or to sell their securities to a third party) or involuntary (as required by a court order, or pursuant to an agreement between the shareholders, including in the framework of the exercise of any drag along right).
When a business comes to its end or when a deemed liquidation event occurs, the assets or proceeds of the sale are used to pay investors, creditors, employees and shareholders, depending on the priority of their claims. But how is this order determined?
When receiving a share in the company, investors usually get preferred shares, which gives them so-called liquidation preferences.
Liquidation preference may be defined as the investors’ right that guarantees the return of their invested capital before any distributions are made to all other shareholders (the holders of the ordinary shares or inferior preferred shares) or creditors. It is usually a clause in an investment agreement, articles of association or certificate of incorporation of a company that determines which series of shares gets paid first in case the company gets liquidated, and how much of the remaining funds after the sale of the assets each of the other interested parties can receive. Preferred shares, in fact, redefine the “waterfall” of funds’ distribution, and create priorities between different classes of shares.
In a sense, the liquidation preference attributes debt-elements to classes of preferred shares, as it provides priority over different classes.
The clause is important for both the investors and the founders of a company.
For investors, the liquidation preference is usually (but not always) used as a “downside protection” to guarantee that they will receive their money before others (and in preference to them) in the event of a liquidation or a deemed liquidation of a company, and thus they may not lose too much if any of their investment. And when the company’s assets are sufficient for them to recover their entire investment, any losses can be avoided or minimized.
For the rest of the shareholders (usually – the founders and employees holding ordinary shares, or holders of classes of inferior to the class of preferred shares being protected), it is important to obtain guarantees that this condition does not treat them unfairly if their startup is liquidated, goes bankrupt or is sold, with a result that gives the entire liquidation money to the investors, which can be a disincentive to all the other shareholders.
Liquidation preferences may have different manifestations. There are basically two main types of liquidation preferences: the non-participating and the participating.
Non-participating liquidation preference means that the investor (who holds the preferred shares) gets back the invested funds and does not take part in a distribution of the remaining proceeds. For example, if the investment amount is $1 million, the investor holds 20% of the company, and if the company is sold for $3 million, then the non-participating investor gets back his $1 million, and the remaining money can be distributed among other claimants. This happens because a pro rata distribution would yield to the investor less than its original investment (20% * $3 million = $0.6 million).
The non-participating mechanism remains true to the original intent of the liquidation preference mechanism as it protects only in a downside scenario. Accordingly, if the company in the example would have been sold for $0.9 million, the liquidation preference would entitle the investor to the entire proceeds of the sale.
The non-participating liquidation preference allows the investor the option either to receive its investment back, or to share its respective pro rata based on funds or assets received, whichever is higher.
Participating liquidation preference gives an investor both the right to get the investment back and to take part in the distribution of any additional remaining proceeds according to the percentage of his share. A more aggressive approach would be to take a certain multiplier over the original investment amount (2-3x), and then share the remaining proceeds according to the percentage of his share.
So, if $1 million is invested and the company is sold for $3 million, the investor receives his investment back (with 1x, 2x and so on), and also can take part in a distribution of additional money according to his share in the company. A participating mechanism that includes a certain multiplier is also called “a dip,” with customary multipliers being 2x (a “double dip” or 3x (a “triple dip”), because it gives an investor the guaranteed return in the event of a successful outcome.
Of course, including “a dip” is a less preferable option for the founders of the company, but under certain circumstances they may still agree to this when market terms make it difficult for them to raise funds.
There is also another point worth mentioning…
The founders can negotiate a certain valuation hurdle, that, if achieved, can nullify the participating liquidation preferences, and force the holders of preferred shares to receive their pro rata share out of the funds and assets of the company. This means that the agreements between founders and investors may contain a certain value of the company or a return of investment for the investors (for example 2x or 3x), and when it is sold for that price or higher, the liquidation preferences do not apply. This is also a good incentive for the founders to do their best to maximize the value of their business.
DISCLAIMER
This content is brought to you for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained on this website constitutes a solicitation, recommendation, endorsement, or offer by any person or any third party service provider to buy or sell any securities or other financial instruments in this or in in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction.
THIS ARTICLE IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DO NOT CONSTITUTE LEGAL ADVICE. THIS ARTICLE IS PROVIDED WITHOUT ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING AS TO ITS LEGAL EFFECT AND COMPLETENESS. THE INFORMATION SHOULD BE USED AS A GUIDE AND MODIFIED TO MEET YOUR OWN INDIVIDUAL NEEDS AND THE LAWS OF YOUR STATE, BY INDEPENDENT COUNSEL YOU RETAIN. YOUR USE OF ANY INFORMATION CONTAINED IN THIS ARTICLE, IS AT YOUR OWN RISK. WE, OUR EMPLOYEES, CONTRACTORS, OR ATTORNEYS WHO PARTICIPATED IN PROVIDING THE INFORMATION CONTAINED HEREIN, EXPRESSLY DISCLAIM ANY WARRANTY, AND BY DOWNLOADING OR USING OR RELYING ON THIS ARTICLE; NO ATTORNEY-CLIENT RELATIONSHIPS ARE CREATED. DO NOT USE THIS ARTICLE WITHOUT AN INDEPENDENT LAWYER YOU HAVE SPECIFICALLY RETAINED FOR SUCH PURPOSE.
© 2022 Yair Ud
