What is a liquidation preference?
The name of this instrument can be misleading as it is most often associated with a cash distribution mechanism in case of the company’s liquidation. This is only partly true. The setup of the liquidation preference covers not only the liquidation of the company, but also its sale to third parties, the sale of assets, as well as mergers or amalgamation with another entity. Historically, it has been the case that in the term sheet almost all events that may result in payouts to investors are commonly called a “liquidation event” though in reality quite often it is not a case of a company’s liquidation.From an economic perspective, the liquidation preference is a mechanism for protecting investors’ interests in case of the sale of the company they invested in at a value below the one that the investors contributed or in case of the liquidation of the company.
From a legal perspective, the liquidation preference is a mechanism allowing the investors (holders of preferred stock) to receive proceeds from the sale of the company or its assets or in the case of its liquidation on a priority basis and to a certain guaranteed amount.
In other words, the liquidation preference implies that investors holding preferred stock will receive money before holders of common stock.
There are four features of the liquidation preference that you need to take notice of:
Multiple
The liquidation preference multiple shows the ratio of the investor’s original investment to the return on investment. This feature can be best explained using an example. Let’s suppose the term sheet states that a round will stipulate a 1x liquidation preference for an investor. Therefore, if the investor invests USD2 million, in the event of the sale of the company, for example, the investor is in any case (even if the investor’s shareholding in the company is minimal or the company’s value is a little above USD2 million) guaranteed to receive USD2 million. If the company is sold for a price below USD2 million, the investor will receive all the proceeds from such sale as the investor has a preference in the distribution of proceeds from the sale of the company, and the founders will get nothing.
The multiple can be higher than one. For example, if an investor has a 2x liquidation preference, with an investment of USD2 million in the event of the sale of the company for USD10 million, the investor must in any case receive USD4 million, ie two times the amount of the investment made (irrespective of the size of the investor’s ownership stake in the capital — irrespective of the number of shares the investor holds in the company).
Based on our practice, the 1x multiple has been the market standard for quite a long time. Now, the situation has changed a little, but the negotiation of a multiple above one is usually driven by two circumstances. First, this may be the case when there are disagreements about the company’s value and an investor wants to have additional protection of the investment. Second, a multiple above one may be set when an investor has a stronger negotiating position.
Participating and non-participating liquidation preference
The next feature of the liquidation preference allows an investor to choose between two options: the investor may get back only the original investment or get back the investment plus the funds owed to the investor as a company stockholder.
In the first case we are speaking of a so called non-participating liquidation preference, which implies that the investor must choose between two options: the investor either receives the funds due to the investor as a holder of the liquidation preference or converts the shares into common stock and receives the funds due to the investor as a common stockholder.
A participating liquidation preference implies the investor is not given any choice: the investor receives what is due to it subject to the liquidation preference, as well as what is due to it as a company stockholder.
Usually, the market standard is the non-participating liquidation preference. As in the situation with the multiple, the participating liquidation preference provides more serious protection of the investor’s investment and, as a rule, is a non-standard provision in a term sheet.
An overall cap on payouts to investors
A cap is applied in case of a participating liquidation preference. After an investor with a participating liquidation preference receives what is owed to it (a flat sum in the amount of the investments made), the investor will convert its shares to common stock and participate in the distribution of proceeds from the sale or liquidation as a company stockholder. In this case, investors usually set an overall cap on the distribution of funds and such cap is usually the amount of their participation in the company. The cap is usually three times the amount of the investment, ie as a company stockholder, the investor will receive no more than three times its investment.
Preference stack structure
As we mentioned in the previous issue, venture financing occurs in rounds. This implies that investors of each new round receive new preferred stock of their class. Transaction documents usually provide for the seniority of investors and their rights.
Seniority applies to the liquidation preference too: usually the most recent round investors are paid before the early round investors. Accordingly, the latest round investors rank senior in terms of exercising their liquidation preference.
It may be the case that several investors or even groups of investors participate in a round. Usually, in one round, such investors receive a pari passu preference.
Calculating a liquidation preference
By way of illustration, let’s look at how the liquidation preference is calculated based on the example of Zoom, a company organising online conferences. Of course, we do not know what the commercial terms were in each of the funding rounds and what terms were stipulated by transaction documents, but we know the round sizes from public sources, and now the company has successfully made it to the IPO, ie has completed the venture cycle; therefore, this example is convenient for analysis.According to data from public sources, Zoom raised USD276 million in nine funding rounds. Now we suggest considering a number of hypothetical situations and analysing how the financial terms would change for investors and founders depending on the changes in the terms of the liquidation preference.
Favourable scenario (selling above the value in round A)
For convenience purposes, let’s imagine that Zoom did not go public and was instead sold to another company (for example, Google) for USD500 million. In the case we are considering, you are the investor in Zoom and invested USD1 million in round A (from the previous issue you may recall that this round is preceded by pre-seed and seed rounds and, at this stage, the company has already confirmed a product-market fit and applies the raised funds to its own growth and scaling up), with the company being valued at USD9 million. Accordingly, your share in round A will be 10%. For simplicity, we do not take account of the share dilution in the subsequent rounds.
- If you, as an investor, negotiated a 1x non-participating liquidation preference, as an investor in round A you would receive USD1 million if you chose to exercise your preference or USD50 million if you chose to participate in the distribution of proceeds from the sale as a company stockholder (ie you would receive your 10% share of proceeds from the sale of the company for USD500 million). You would naturally choose the second option, as it is more beneficial.
- If you negotiated a 1x participating liquidation preference, you would receive USD51 million: you receive the guaranteed USD1 million as a holder of the liquidation preference plus USD50 million as a result of participation in the distribution of proceeds from the sale of the company among stockholders.
- If you negotiated a 2x non-participating liquidation preference, you would have a choice: to either receive USD2 million as a holder of the liquidation preference or receive the same USD50 million as a company stockholder. Again, the choice would be in favour of the second option.
- If you negotiated a 2x participating liquidation preference, you would receive USD52 million: USD2 million dollars as a holder of the liquidation preference plus USD50 million as a result of participation in the distribution of proceeds from the sale of the company among stockholders.
Above we looked at the favourable scenario where the company is sold to a strategic investor at a good price (value) that exceeds the amount of investment and the previous round’s value (9 million value vs 500 million proceeds from the sale). However, this is not always the case. Let’s imagine that the pandemic did not become the catalyst for growth for Zoom in 2020, the company was unable to compete on the market and in the end was sold at a value of USD 5 million, having narrowly escaped bankruptcy. In this case, the distribution of funds between investors and stockholders would be as follows:
- If you negotiated a 1x non-participating liquidation preference, as an investor in round A you would receive USD 1 million if you chose to exercise your preference or USD500,000 if you chose to participate in the distribution of proceeds from sale as a company stockholder (ie you would get your 10% share of proceeds from the sale of the company for USD5 million).
Of course, the first option would be more beneficial. You take USD1 million of the liquidation preference and then the founders and other investors would have USD 4 million of proceeds from the sale out of which they can receive their own share of the sale proceeds. In this case, the liquidation preference protects the investor from financial losses and the investor gets back the amount it invested. - If you negotiated a 1x participating liquidation preference, you would receive USD1,5 million: you receive the guaranteed USD1 million as a holder of the liquidation preference plus USD500,000 as a result of participation in the distribution of proceeds from the sale of the company among stockholders. In this case, founders and other stockholders will have to settle for an amount of USD3.5 million.
- If you negotiated a 2x non-participating liquidation preference, you would have a choice: to either receive USD2 million as a holder of the liquidation preference or receive USD500,000 dollars as a company stockholder. It is most likely that you would choose the first option, leaving other stockholders and investors with USD3 million.
- If you negotiated a 2x participating liquidation preference, you would receive USD2.5 million. In other words, in the given case, holding a 10% share in the company, you can take 50% of proceeds from the sale of the company. The liquidation preference therefore helps to redistribute the risk that the company will not be successful.
We have analysed two hypothetical scenarios. One of them is favourable and the other one is less favourable for the company. There are situations, however, when founders and other investors do not receive anything at all from the sale of the company no matter how much stock they hold.
Let’s suppose that Zoom went bankrupt and its assets were sold to competitors for USD2 million. In such case, if you negotiated a 2x liquidation preference, with the same background data, your preference would equal USD 2million. Accordingly, as an investor protected by a liquidation preference, you will receive all proceeds from the sale of the company’s assets, while the founders and other investors will get nothing.
The meaning of seniority of liquidation preferences
In such situation, the seniority level of preferences is of particular importance. If there were several funding rounds in the company, you should keep in mind that each liquidation preference has a certain seniority status: proceeds from any (even the most successful) sale will be distributed in favour of founders and other stockholders only after all liquidation preferences have been satisfied.
In the situation in question, if the company is sold unsuccessfully and you, as an investor, have a junior liquidation preference (for example, there were three funding rounds in the company and you invested only in the first round), it may be the case that you will receive nothing from the sale of the company even though you are company stockholder with a liquidation preference.
It should be noted that such situations are not uncommon. For example, the virtual events platform and virtual conference company Hopin raised a total of over USD1 billion and was valued at over USD7 billion during lockdowns and the pandemic. However, later on, the company was unable to sustain this value and continue further growth. Conversely, with the end of the pandemic, interest in virtual events began to wane. In the end, the company was sold for USD 15 million. We do not know all commercial terms of the deal, but it is most likely that only the most recent round investors were able to get back their investments and, at that, only partly. It is most likely that the founders did not receive anything, like the earlier round investors, since the later round investors usually have preference over them.
Share dilution and its consequences
You should keep in mind that in real life, with every round the investor’s share is diluted because during each round the company issues new stock to other investors. For example, after round A the investor’s share was 10%, but after a few subsequent rounds it will only be 7%, since new funding was raised, more stock was issued and the round A investor did not buy such new stock (there are situations when investors maintain the size of their share, but for simplicity purposes, let’s suppose that the investor did not take part in the subsequent rounds). Accordingly, if the company is sold at an average price, the investor will need to calculate what would be best for it: to exercise the liquidation preference or receive the funds as a company stockholder. Considering the dilution, your share may decrease to only a few percentage points in the company capital and then (unlike in the examples that we described above) even the exercise of a 1x non-participating liquidation preference may be more beneficial than participation in the distribution of proceeds from sale.
Legal mechanisms for formalising a liquidation preference
In the USA, a liquidation preference is usually set out in a Certificate of Incorporation. This is a document which, contrary to its title, is in fact a kind of an analogue of a company’s charter as it contains the provisions that are usually included in a company’s charter in the countries of a continental legal system. It usually describes the list of events that put the liquidation preference mechanism into operation. As a rule, apart from the liquation and sale of the company, such events also include the sale of all the company’s assets, the granting of an exclusive licence to a third party, the sale of subsidiaries (where they are critical to the company’s business) and various corporate reorganisations.An example of how a liquidation preference is formalised can be found in a model Amended and Restated Certificate of Incorporation published on the website of the National Venture Capital Association.
In Russian law, structuring a liquidation preference so that this mechanism would be operable causes difficulties. In our opinion, the liquidation preference set-up cannot be effectively structured under Russian law because of a lack flexibility in corporate law, excessive regulation of the activities of non-public companies and the prevalence of peremptory rules in Russian corporate law in general.
When structuring legal mechanisms of exercising a liquidation preference in a Russian limited liability company, most difficulties are often connected with the inability to issue “preferred” stock (participation interest) in a Russian limited liability company and stipulate corporate rights for various classes of such “preferred” stock (participation interest). The concept of regulating the activities of a limited liability company nowadays places special importance on the individual exercising control over business rather than on the “class” of the investor’s participation in the capital. Russian law, for example, provides for an institute of additional rights of company members and an ability to change the profit distribution order by the company’s charter, but these instruments do not work over time as required for the investors’ interests.
This results in a situation that structuring a liquidation preference triggers high risk. For example, the provisions on the liquidation surplus or liquidation quota (the assets that the company members receive in case of the company’s liquidation) are dictated by statutes. Therefore, they cannot be changed by a company’s charter or an agreement of the parties. This does not allow the investor to stipulate that it is the investor who will have preference over other company members in case of the company’s liquidation. In addition to this, there is no possibility to formalise the disproportionate distribution of assets in case of the company’s liquidation.
Theoretically, the liquidation preference could be structured through contractual mechanisms, but there is currently no case law on such kinds of instruments. Given that venture capital financing is in principle quite risky, as a rule, it is not reasonable for investors to assume additional legal risks.
The specifics of Russian regulation described above is one of the reasons why in practice most venture capital investments in Russian companies are structured through holding companies in Cyprus, Delaware (USA), Singapore or Ireland, making it possible to apply the more convenient foreign law.
In our next issue we will talk about the mechanism that allows investors to maintain the size of their ownership stake in subsequent rounds (a pro rata right) and explain why it is so important to investors and company founders.
