A liquidation preference is a commonly requested investor term. The idea around a liquidation preference is that the investor will receive their funds out of the business prior to the existing shareholders at the time of investment.  A liquidation preference is often inserted into deal terms by the investors in a major round of financing and not before then, and here’s why.

Liquidation preference discourages outside investment and overcomplicates the cap table

A liquidation preference provision could be inserted by the founders, but that would be unusual in a company without outside investors because: (1) funds advanced are often treated as a shareholder’s loan – which is effectively very similar to a liquidation preference; and (2) if the founders associate a preference to the shares they hold, that corresponds to a preference for “sweat equity”, which is difficult to assign a precise value.

To put it another way, most investors want to know that the founders are taking the most risk and have the most to gain or lose.  There’s a sense of unfairness to put non-cash investments ahead of investor funds that are usually sourced with after-tax funds.

Review a liquidation preference clause

Here’s what a sample liquidation preference clause might look like:

On any liquidation or winding up of the Company, the holders of Preferred Shares will receive in  preference to the holders of the Common Shares a per share amount equal to the greater of: (i) the Original Issue Price plus any declared but unpaid dividends, or (ii) the amount such holder would have received had the Preferred Shares been converted into Common Shares immediately prior to the liquidation or winding up (the “Liquidation Preference”).

So if the Original Issue Price is defined as three million dollars, three million dollars must go to the original investor before any funds are available to other investors.  Such a clause may go on to say:

After the payment of the Liquidation Preference to the holders of the Preferred Shares, the remaining assets of the Company shall be distributed to the holders of the Common Shares on a pro rata basis.

The investor may also try to negotiate a “hurdle” rate so that a minimum return on investment is achieved.  See for example the following language, under which a 20% hurdle is desired:

…the Investor will receive, in preference to all other shareholders of the Company at the time of Liquidation, an amount that is the greater of: (a) 1.2 times the amount of the Proposed Investment; and (b) the liquidation value of the Shares on an as- converted basis into common shares in the capital of the Company.

Liquidation preference at a later rounds

A savvy investor will want to Introduce a liquidation preference in an early funding round, and the founder should try to avoid allowing this.  Normally a liquidation preference will require the articles of incorporation to be amended to add a new class of preference shares.   Allowing in a liquidation preference to one share class may result in a difficult negotiation with future investors, who, if they are “writing a big cheque” will almost inevitably require that the liquidation preference be removed, or who may alternatively require that another class of preferred shares to be stacked on top of the existing preferred shares.

Stacking new preference shares on top of old makes the company capitalization table more and more difficult to understand, and a new investor may either request that all prior investors agree to swap their shares for a simpler class (a difficult thing that usually the founder would be requested to negotiate), may (as noted above) be scared off from investing, or may stack another new share class on top of the prior.

Absorbing new investors into a preferred share class

To address the issue of stacking new share classes on top of the old, new Investors could simply be absorbed into an existing preferred share class (more shares of a preferred share class could be issued), and old and new shareholders could agree that both old and new would share in any liquidation proceeds pro rata until they are paid out in full.  This would of course require some negotiation.

ESOP and liquidation preference

One final note, an ESOP share class may come with no liquidation rights, as there is often no cash (only sweat) that is invested along with ESOP shares.  A special class of shares for ESOP shareholders may come with no access to the remainder of funds upon the bankruptcy of a company, although it would be unusual and unfair for ESOP shares to not receive payment in the event of a successful “exit event.”

Takeaways

• Preferred shareholders are at the front of the line
• Read the articles carefully and check the share capitalization table to know what each investor is receiving
• Founders should try to resist issuing preferred shares for as long as possible
• ESOP Shareholders may not be eligible for a share of funds in the event of bankruptcy – check the articles