In situations where companies are considering an investment form an institutional investor, the concept of liquidation preference will be certain to come up. The investor will want certain privileges and protections in exchange for making an investment in a start-up or early stage company. These privileges and protections can take many forms but the liquidation preference is one of the main ones to be aware of.
What is it?
Liquidation preferences appear in charter documents such as articles or certificates of incorporation. In simple terms liquidation preferences are those that specify what will happen to a class of securities in the event of a major change in the company. The major change could be a liquidation as in a bankruptcy, a financing event, a sale or acquisition, dissolution, or any other defined event. In other words if X occurs then Y will happen. Both the X and the Y can be the subject of negotiation but the Y is usually the harder of the two to come to an agreement on.
Liquidation preference in detail
A liquidation preference is a provision that indicates the preference that a class (most often preferred stock) will have over another class in the event of a liquidation. Oftentimes this means that the preferred stockholder gets paid first before common stockholder if, for example, the company is dissolved and the assets sold.
Types of liquidation preferences
There are three types of preferences:
3. Partially participating
Non-participating is the most favorable for the company. It allows the preferred stockholder to be paid first in the amount of the original investment together with any accrued and unpaid dividends before the common stockholder is paid.
Participating is the least favorable for the company. It provides that the preferred stockholder to be paid first in the amount of the original investment together with any accrued and unpaid dividends, and then the preferred stockholder shares the remainder of the proceeds with the common stockholder creating a double payment scenario.
Non-participating is an intermediate approach. It is similar to participating preferred but the total return to the preferred stockholder is capped at some figure above which the common stockholder receives all of the proceeds.
From a company perspective the non-participating preference is the most attractive and should be the starting point for negotiations. From an investor’s perspective the participating preference is the most attractive but the actual impact of this on a liquidation event could have a demoralizing effect on management and the employees.
Charter documents may contain liquidation preferences and liquidation multiples, conversion rights, voting rights, dividend rights, and protective provisions for preferred stockholders. All of these need to be reviewed to give an accurate picture of the rights that the investor is getting in the company and the balance of power if they are accepted.