If you are an entrepreneur or in the top management of a growing start-up, your primary focus is probably on ensuring smooth operations, creating business opportunities, recruiting the right talent, and streamlining processes in your organization.
Thinking about which investors get paid off first if your venture gets sold to a larger company is not an everyday affair. However, it is important to know about this from the get-go so that there are no surprises if the situation arises.
Liquidation preference, as the name suggests, gives preference to certain investors when complete or partial liquidation occurs. Liquidation preference cannot be understood in isolation. It needs to be seen alongside the capital and possibility of liquidation. These are discussed in the following section.
Understanding Liquidation Preference
To understand liquidation preference, let us zoom out and look at the capital components of a company. We also need to understand the context for liquidation preference: a liquidation event.
Types of Capital
The capital portion is divided into different classes. Two broad classifications are equity share capital and preference share capital. These can have further sub-classifications based on the rate of dividend payout and other factors.
The basis for differentiation between classes is the priority given to the respective shareholders for different aspects. When it comes to major business decisions, equity shareholders are prioritized and given voting rights.
On the other hand, preference shareholders are given more financial priority. This means that the money that they invested is repaid first if and when the company gets liquidated. They are also entitled to fixed dividend payments, while equity shareholders are not. This brings us to the following question:
What is Liquidation?
Liquidation refers to a portion or the entirety of a company being sold in exchange for cash. A stake in the company might be liquefied to generate funds. There are two types of liquidation – complete and partial.
Complete liquidation is when the entire company is sold off and the creditors and investors are settled from the proceeds of the sale. Partial liquidation is when only a portion of the company is sold off and the funds may either be reinvested into the business or might be used to settle any outstanding amounts.
All the capital stock on the company’s books is canceled in case of complete liquidation, while some of the shares are retained in case of a partial liquidation.
What Can Trigger Liquidation?
An entrepreneur commences a business with the intention of making it grow. However, there are certain circumstances in which liquidating the company might be necessary or even beneficial. There are two types of situations that can trigger liquidation – voluntary and compulsive.
Voluntary liquidation happens when the founders or management decide to liquidate a part or the whole of the company for business reasons. For example, the management may decide to sell off one of their factories to settle a debt that may cause legal problems. A lucrative merger or acquisition may entice an entrepreneur to sell the business, bringing a liquidation event.
Compulsive liquidation is when the company has to wind up its operations as mandated by law.
How does Liquidation Preference Work?
Liquidation preferences are dynamic and there can be multiple permutations and combinations of their types based on the factors discussed below.
Liquidation preference comes with a multiple like 1X, 2X…10X. In the event of liquidation, the number beside the X is multiplied by the original investment amount. The company needs to pay the preferred shareholders this amount before settling other shareholders. In case the proceeds are insufficient to cover this amount, the entire proceeds go towards settling investors with a liquidation preference, once the debts, if any, are settled.
2. Level of Participation
There are three variants of liquidation preference depending on the level of participation. These are:
Participating: Participating preference is when the investor is entitled to the fixed multiple as well as a share of the proceeds after the preferential part is paid. Due to this additional benefit for the investor, this type is also known as ‘double-dip participation preference’.
Non-participating: This is when the company’s liability is limited to the multiple that is agreed upon. The proceeds from liquidation after repayment of the preference shareholders are entirely for the equity shareholders. They are also known as ‘straight preference’.
Capped: This is a combination of participating and non-participating preference. The investors are entitled to a sum over and above their multiple. However, this amount is capped. . This variant is also called ‘partially participating preference’. An investor may convert their preference shareholding to equity in order to have a greater entitlement.
The seniority structure determines the order in which investors are repaid in case of a liquidation event. There are three types, which are explained below.
Standard Seniority: This is when the most recent investor is repaid first, followed by a payment to the investor immediately preceding the most recent one, and so on.
Pari Passu: The phrase means ‘on equal footing’. A pari passu structure treats all investors at the same seniority level and proceeds are distributed on a pro-rata basis.
Tiered: This is a combination of standard and pari passu seniority. Shareholders from various funding rounds are grouped together similar to standard seniority.
In a Nutshell
Liquidity preference is a way of securing returns for investors. This is a feature that can be used by startups to attract funds. An entrepreneur needs to know the context and types of liquidation preference so that they know exactly how much they need to pay the investors in case a liquidation event occurs.
To simplify this, startups can use cap tables that clearly display this information and help the management be prepared. Not convinced? Here are three more benefits of having a cap table. trica equity’s cap table can help you in other ways too! Click here to know more.