LIQUDATION PREFERRED STOCKS Essay Example

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LIQUDATION PREFERRED STOCKS

Liquidation Preference

After “price” Liquidation Preferences are considered by venture capitalists (VC) as the most important “economic term” so far. The liquidation preference usually decides on how the cake will be dissected if incase a company undergo some event of liquidation. Liquidation preference is made up of two components namely: the actual preference and participation. To be clear here, the term liquidation preference is more often, than not, deals with money paid or returned to a certain financing series (A, B, C …etc) of the company’s shares (stock) before any other series of stock is paid. This means that the holders (investors) of the Series A, B, C, et cetera Preferred usually gets certain multiple ([x] the Original Purchase Price plus any declared but unpaid dividends) of the initial investment per share before the common stock holders receives any consideration. Liquidation preferences sometimes can go beyond the initial purchase price of the stock and the liquidation preference of the holder can dictate the right to be paid first before anybody is considered (Woronoff & Rosen, 2005).

In case a company undergo liquidation event, investors will either choose to exit as preferred stockholders and enjoy the benefits of their liquidation preferences or take the common stockholders exit.

A “1x” liquidation preference has been the standard for quite some time until 2001 when it was increased to the multiples of “10x” by investors.

In many developed nations, venture capital is known to contribute a lot to the country’s economic growth. This is because VC firm generates and increases capital and selects collection companies to fund or rather to invest in. Along the way, the VCs give advices to the chosen companies and can shuffle or in other words replace the founders of these companies. Since VCs are smart; they can “exit” their investments in the portfolio companies before the fund’s life ends and return capital to investors. Once VC decides to exit, it will choose one of the three exit forms:

  • An initial public offering (IPO) of the portfolio company’s shares

  • The sale of the VC’s shares into the public market (trade sale)

  • Dissolution and liquidation of the company

Of these three types of exits, IPOs have been scrutinized mostly because of its public-disclosure on its exit as required by the security laws. The other form of exits takes place in the shadows and no one knows much about it.

Another thing that we need to know is to find out if investor shares (stocks) are participating or not. In most cases, people think the term “liquidation preference” to mean both the preference and the participation. Participation can be divided into three categories namely:

  • Full participation,

  • Capped participation and

  • Non-participating.

Participation:What this means is that, if in case a company undergoes liquidation event, the payments are made to the holders of the Series A Preferred and after that, the remaining assets are then dispersed ratably to the rest of stockholders of the Common Stock as long as the holders of Series A Preferred will stop participating once they get their share.

Capped participation: Means that stock will be shared on a pro rata basis and participation features is limited and investor may not receive beyond a given multiple return.

Nonparticipating: This kind of preferred stock is the one that gives the investor a flat rate of dividend and nothing else. This means the dividend will not depend on the performance of the company, but instead remains constant all times. However, not like the common stock holder, nonparticipating stockholders have a right to have a minimum dividend. Most preferred stock is nonparticipating as chosen by Beatrice in our case.

If the liquidation preference is non-participating as suggested by Beatrice, this is capped at the “up front” amount and the general meaning of this is that the holders of these Preferred Stocks are on the save side because of what is called “down side” protection just in case there is a sale of the corporation, though owning these preferred stocks is limited. Also on the other hand, investors can convert their Preferred Stocks to common stocks so as to have unlimited up side on the investment although they have to liquidation preference (Leisen, 2012).

Just as in the case of Beatrice and Joe, for example, if the stockholders (investors) put in $1MM for 40% of the company (corporation). If the company is sold for $2MM at the later times, the investors would receive their money through liquidation preference and another 50% of the sale proceeds. And in case the company was sold for $10MM, nonetheless, the stockholders would be on the better side if they convert their preferred shares to common shares and their 40% of the total will yield them $4MM. But in the case of a non-participating preferred as suggested by Beatrice, the investor can convert their preferred stocks to common stock and this will yield them a whopping $8MM of the corporation.

With participating preferred as I have explained above, the stockholders normally enjoy the liquidation preference and the better part of it is the owning of the shares that were converted from the preferred. The stockholders in the $10MM sale case would get $4MM as their liquidation preference, and on the remaining $6MM converted to common stock, they would participate with the holders of common stock and so get $2.4 MM of the remaining proceeds (40% * $6MM) for a total return of $2.4 MM. Therefore a participating preferred is the best bet for investors because it is less risk with a lot rewards.

And if the participation is capped, the stockholders get their money back first, before they participate with the common stockholders and they will not stopped until they hit a total of [2X – 5X] of their investment. For example, if stockholders had participation up to 2X of their investment as suggested by Beatrice in our case, and the corporation were sold for $10MM as mentioned above, the investors of Preferred Stock would get $1MM and then take 40% of the remaining $9MM, which is 3,600,000. Now add that to the $1MM off the top, and the sum is $4.6MM. Because this amount exceeds the cap, however, the liquidation preference would not go beyond $2MM. At a $10MM exit for the investors, and if you convert everything to common stock and taking 40% of the total (which would yield 40%*$10MM = $4,000,000), you will find out this liquidation preference is still better. $11MM exit is now the inflection point for converting to common. Over $11MM, the stockholders would convert to common stock take their pro rata share of the sale proceeds and forget about the liquidation preference.

Another important thing that we may need to understand more when it comes to preferred stock is the actual meaning of the phrase “the multiple of the Original Purchase Price (the [x])”. If you hear the participation multiple is 2 (two times the initial purchase price), then this means the preferred, on a per share basis, would stop participation once they hit 200% of its original purchase price has been returned (including any amounts paid out on the liquidation preference). This is not merely an additional 2x return, but an addition 1x, with the assumption that the liquidation preference was a 1 times money back return.

When dealing with a series A or B term sheet, it is more easy to understand and assess liquidation preferences but it may get more knotty to understand what is going on as a company matures and sells more series of equity and this can be really challenging. The approach to liquidation preferences among multiple series of stock varies and it get more complex for no reason.

Deciding which approach to use is not an easy thing but the negotiating powers of investors involved can influence it, the ability of the company to look for more financing, and the economic status existing money structure.

Most executive officers or professional usually do not want to gouge their companies with excessive liquidation preferences as this will lower the potential image or the value of the management. Most investors will prefer a combination of “the best price” and at the same time making sure there is “maximum motivation” of the employees and the management as a whole.

References

Woronoff, M & Rosen, J. 2005. Effective vs. Nominal Valuations in Venture Capital Investing, 2 N.Y.U. J.L. & B US 199, 218.

Leisen, D.P.J., 2012. Review of Financial Economics Staged venture capital contracting with ratchets and liquidation rights. Review of Financial Economics, 21(1), p.21-30.