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LIQUIDATION PREFERENCES

10/28/2022

1 Comment

 
Written by Mercer Timmis*

What are Liquidation Preferences?

A liquidation preference is a contractual right that may be negotiated by a venture capital firm while providing financing to a business. A liquidation preference entitles preferred shareholders to receive a certain amount of money on the company's liquidation before anything is paid out to the holder of the other classes of shares.[1] Liquidation preferences may be triggered by events such as bankruptcy, winding up the business, an extraordinary sale of all or substantially all of the company's assets, or a change of control of a company.
Usually, preferred shareholders get an amount equal to their original purchase price plus any accrued and unpaid dividends (the" liquidation price"). However, venture capital investors ask for additional features, such as a multiple liquidation preference. A multiple liquidation preference gives the investor the right to receive between 1 to 3 times the liquidation price.[2]
 
Current Relevance
From 2020 to 2021, venture firms saw a record level of inflowing capital that pushed company valuations higher. This business-friendly market meant that investors settled on a 1 times liquidation preference which ensured they would be paid back their initial investment before founders and employees.[3]
Conversely, 2022 presents a different market where venture capital investment dropped to a six-quarter low amidst increasing interest rates, high levels of inflation, and a declining stock market. This weakened funding environment creates a lower risk appetite for investors where investors ask for more onerous terms. As such, investors are asking for a 2 to 3 times liquidation preference, meaning they would be paid back double or triple their money before other stakeholders.[4] 
 
The Dilemma
Generally, a company's valuation tends to increase for each financing round. However, the current economic climate brings unfavourable company valuations and leads businesses to agree to more onerous terms to prevent a 'down round.' A down round occurs when a company raises money at a lower valuation than its previous round. The consequences of a down round are two-fold. First, raising funds at a lower valuation has a dilutive effect on existing shareholders. Second, it is a red flag that reduces investor confidence and employee morale.[5] As such, liquidation preferences are prevalent in the current market because investors will agree to funding valuations equal to or higher than a company's previous round in return for 2 or 3 times multiple. These terms are attractive because, despite the underlying difficulties of the business, the investor is receiving 2 to 3 times their investment.
 
Options for the Business
If a company faces onerous liquidation preferences, the following compromises are available: First, suggest that the liquidation preferences operate only against management and founders' shareholding rather than against the equity of other investors (i.e., any friends or family). Second, place a cap on the return to the preferred shares so that in the event the company sees modest success, the preferred shareholders will do better by converting to common equity rather than relying on the liquidation preference. 
Finally, when negotiating the terms of liquidation preferences, they should not provide for a "change of control" mechanism that results in the deemed liquidation in the event of an equity investment involving more than 50% of outstanding shares. Instead, the threshold should be much higher.[6]

Footnotes:
[1] Bryce C. Tinge, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practices, 3rd ed (Canada: LexisNexis Canada Inc, 2018). 
[2] Ibid.
[3] The Information, “Startups Avoid Valuation Cuts with ‘Up Rounds in Name Only’ (11, October, 2022) online: The information < https://www.theinformation.com/articles/startups-avoid-valuation-cuts-with-up-rounds-in-nameonly?utm_source=substack&utm_medium=email>.
[4] Bloomberg, “VCs Need the Good Tweets” (13, October, 2022) online: Bloomberg, Matt Levine < https://www.bloomberg.com/opinion/articles/2022-10-13/vcs-need-the-good-tweets>.
[5]Supra, note 1.
[6] Ibid.


*Mercer Timmis
J.D. Candidate 2023
University of Calgary, Faculty of Law


1 Comment
Valen link
12/10/2024 11:17:52 pm

What strategies can companies adopt to navigate the challenges of down rounds while maintaining investor confidence, minimizing shareholder dilution, and preserving employee morale? <a href="https://jakarta.telkomuniversity.ac.id/en/google-cloud-platform-technology-services-that-make-it-easier-for-students/">Tel U</a>

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