Liquidation preference provisions
In simple terms, liquidation preference provisions determine the order in which the company’s investors/stockholders will receive their money back, and how much the investors/stockholders are entitled to in the event that the company is liquidated. These provisions are particularly appealing to investors who are investing in high risk companies, such as a venture capitalist investing in a start-up.
This added layer of protection is particularly appealing to investors who are investing in high risk companies, such as a venture capitalist investing in a start-up. If liquidation preference provisions were not implemented then the investor could expect a lower or no return on their investment in an insolvency situation.
The size and structure of the liquidation preference is negotiated to reflect the risk inherent in the investment company: the higher the risk, the higher the return. Many factors will be considered in this calculation, including the valuation of the company.
Sale of a company
Start-ups usually have two types of shares: ordinary shares and preferred shares. If a company is sold then the sale proceeds are automatically transferred in equal parts to all ordinary shareholders on a pro rata basis. However, any preference shareholders will receive their investment first, before the balance is dividend amongst the ordinary shareholders. For example, if an investor invested £500,000 in return for preferred shares in a company which is subsequently sold for £3 million, the investor would receive their £500,000 investment back first, before the remaining £2.5 million is divided amongst the ordinary shareholders.
Liquidation preferences are only attached to preferred shares, typically issued to investors during financing. A liquidation preference provision is therefore only really relevant where a private company exits through acquisition, merger or sale of assets because of insolvency. Liquidation preference provisions tend not to be as relevant to public companies because an initial public offering typically converts preferred shares into common shares automatically for those shareholders.
Three types of liquidation preference provisions
- Non-participating, which grants the investor(s) the right to recover an amount equal to their investment in the company or a multiple of it (for example, double or triple the investment). After receiving the preferred amount, the remaining proceeds are distributed among the remaining shareholders, excluding the investor(s). This liquidation preference is often most favourable to the founder(s) of the company.
It is for the investor(s) to decide whether they will exercise the liquidation preference or convert their preferred shares into ordinary shares and be paid a proportion of the proceeds based on their equity ownership of the company.
For example, if an investor invests £1 million in a company with a 1x non-participating liquidation preference in exchange for 20% ownership and that company is subsequently sold for £2 million then the investor has two options: i) exercise the liquidation preference to receive their £1 million investment back, or ii) convert those preferred shares for 20% of £2 million (£400,000). In this scenario, the investor is likely to choose the first option. In this scenario, for the investor to be indifferent as to which option to exercise (also known as the conversion threshold), the exist price would need to be £5 million. An exit price below the conversion threshold would encourage the investor to exercise their liquidation preference. An exit price above the conversion threshold would encourage the investor to convert their preference shares into ordinary shares/common equity.
- Fully participating, which grants the investor(s) the right to recover their investment, or a multiple of it, and participate in the distribution of the remaining proceeds to the ordinary shareholders on a pro rata basis. The investor(s) can therefore receive their preference amount plus a pro rata proportion of the remaining proceeds. This liquidation preference is often most favoured by the investor(s) of a company.
- Capped participating, which grants the investor(s) the right to recover the amount of their investment with priority over the rest of the shareholders and to participate in the distribution of the remaining proceeds on a pro rata basis, but only until the maximum cap amount is reach. The remaining funds are then distributed exclusively among the ordinary shareholders and the preferred shareholders do not receive anything. The capped participating liquidation preference can therefore create unfair scenarios for initial investors. The investor must choose to convert their capped participating liquidation preference shares to ordinary shares in order to receive a return greater than the cap, if sufficient funds are available. The cap essentially introduces a conversion threshold that might not otherwise exist.
Some investors, particularly venture capitalists, not only seek liquidation preference provisions in connection with actual liquidation or winding up of the company, but also where there is a ‘deemed liquidation’. Such events are thought to include a merger, acquisition, change of control or consolidation of the company, other restructuring or sale of all or most of its assets. These are thought to be triggering events which necessarily trigger payment of the liquidation preference provisions in one of the above formats, unless the shareholders majority elect otherwise.
Although deemed liquidation events are relatively standard across transactions and are therefore rarely litigated, it is still important to recognise the clause on both parties’ sides to avoid doubt or confusion. Essentially, should the transaction fundamentally change the operation or ownership of a company, it is likely to be a deemed liquidation.
Some start-ups will be founded by single entrepreneurs; however, the majority will have more than one investor from the start. This requires ranking the investors based on their seniority in order to determine where each investor falls in that pecking order. Liquidation preference provisions can each follow different structures.
A standard seniority ranking means that the liquidation preference will be in order from the latest round of investors to the earliest round. In the event of liquidation (or deemed liquidation), series A investors will always be the last ones to be paid back. For example, if both series D and series A investors invested £1 million each, series D investors would receive all of their £1 million investment and the series A investors would receive nothing. The reasoning behind this is that because start-ups generally struggle to raise funds at the beginning of their life cycle, the later stage investors are in a stronger position to request seniority preference as the earlier stage investors depend on the later stage investors for survival.
A pari passu ranking means that all preferred shareholders across all stages of investment will be at the same level of seniority and each investor will therefore receive equal amounts from the company. The shareholders essentially share the proceeds on a pro rata basis until all proceeds are disseminated among the shareholders. This ensures that all investors will receive something.
However, this structure becomes complicated in non-participating preference provisions because it leaves investors with two options on whether to exercise their liquidation preference or convert their preference shares into ordinary shares. Each shareholder’s decision is likely to depend on the other shareholder’s decision. For example, if shareholder A holds 50% of the shares in a company which is sold for £10 million and shareholder A decides to convert their preference shares to ordinary shares, shareholder A’s 50% shareholding may not equate to £5 million after converting their shares. If every other investor chooses to use their liquidation preference, shareholder A’s 50% shareholding will receive a much smaller return. This structure is usually found in start-ups founded by individuals who are already successful in business. As there is no shortage of funding, there is no need to provide seniority to secure a future investment.
Recent market trends have moved away from the more exotic structures with high liquidation preference provisions which were common in the early 2000’s towards much simpler structures with lower liquidation preference provisions. This change may be due in part to a shift in founders/investors’ expectations of the timing and valuations of the business on exit. As the time taken to achieve an exit from a company has increased, valuations have deceased which has led founders to be less willing to offer lucrative liquidation preference provisions. The most common liquidation preference structure is a non-participating preferred stock with a 1x liquidation preference.
SEIS/EIS tax relief
Liquidation preference provisions are generally incompatible with SEIS/EIS. Preference shares are more common with non-SEIS/EIS investors and venture capitalists investing in later funding rounds. This is not surprisingly given that SEIS/EIS tax relief is aimed at providing greater tax benefits to start-ups who are struggling to raise finance as they are considered higher risk.
However, liquidation priority on exit holds that investors may be eligible to receive a different class of Ordinary shares to the founders – ‘A Ordinary shares.’ A Ordinary shareholders would not necessarily get their shares back first, but will be split between all shareholders. Once the investors have received their money back, any remaining assets are then distributed on a pro rata basis.
This area of the law is not particularly clear. Under Article 5 of the Practical Law Drafting Notes to BVCA Articles of Association for Early Stage Investments, Series A shareholders are entitled to receive the preference amount prior to any other shareholder. This will ensure that if there are only limited assets remaining after payment of the company’s liabilities, the investors may be able to recover some of the money invested in that company. Where there has been a shortfall in the total preference amount, the clause should be drafted to make express provision for allocation of surplus assets amongst investors. The preference provision should detail the exact amount which is intended to be returned, typically this is a sum per share equal to the subscription price paid plus any arrears of dividend on that share paid by an investor.
To ensure that the preference provisions are SEIS/EIS compliant, the provisions should be drafted very clearly and precisely within the company’s articles of association. This is on the basis that the liquidation preference is what the investor wants and the founder is willing to offer (given the less favourable financial position it would put the founder in).
Few investors are aware of this SEIS/EIS compliant liquidation preference provision. If you would like further advice or assistance on this, please get in touch with firstname.lastname@example.org with an introduction and breakdown of your situation and we will get back to you.