By: Robert C. Hackney
I will not only give you the definition of liquidation preference as it relates to preferred stock, but I will also give you clear examples of the variations so that you can fully understand the risks and rewards involved.
In the beginning
Companies that anticipate multiple rounds of financing are typically organized as “C” corporations. As a C corporation, when your Articles of Incorporation or Certificate of Incorporation (same thing, different name), are filed, you can create a class of stock known as preferred stock. (I will provide an example below). This is usually done by authorizing a number of shares as preferred stock, but not initially designating any particular preferences for the class. This is commonly referred to as “blank check preferred.” Don’t forget that an S corporation can only have one class of stock, and is prohibited from having preferred stock, so do not file an S election when you incorporate.
Your Articles (or Certificate), will say that the Board of Directors has the right to set the preferences for the preferred stock. There are obviously many preferences, like voting rights, conversion rights, preferred dividends, and usually most importantly, liquidation preferences.
The following is a sample of what this portion of the incorporation document looks like with blank check preferred:
“Section 1. Authorized Shares. The total number of shares which this Corporation is authorized to issue is 10,000,000 shares of Common Stock of $0.001 par value and 1,000,000 shares of Preferred Stock of $0.001 par value. Preferred shares may be issued from time to time as the Board of Directors may determine in their sole judgment and without the necessity of action by the shareholders.”
When the Board of Directors determines that is should issue some of the preferred stock, it is typically issued in a “series” that does not consist of the entire class of preferred stock. Using the example above, the Board of Directors is authorized to issue up to 1,000,000 shares of preferred stock. For clarity, and so that there is no question about the extent of its authority, I usually add another provision to the Articles (or Certificate) that says something like this:
“This corporation’s board of directors (the “Board of Directors”) shall have the full authority permitted by law to divide the authorized and unissued shares of Preferred Stock into series, and to provide for the issuance of such shares (in an aggregate amount not exceeding the aggregate number of shares of Preferred Stock authorized by this corporation’s articles of incorporation (as amended or restated from time to time) (the or these “Articles”)), as determined from time to time by the Board of Directors and stated, before the issuance of any shares thereof, in the resolution or resolutions providing for the issuance thereof. The Board of Directors shall have the authority to fix and determine and to amend the number of shares of any series of Preferred Stock that is wholly unissued or to be established and to fix and determine and to amend the designation, preferences, voting powers and limitations, and the relative, participating, optional or other rights, of any series of shares of Preferred Stock that is wholly unissued or to be established, including, without limiting the generality of the foregoing, the voting rights relating to shares of such series of Preferred Stock, the rate of dividend to which holders of shares of such series of Preferred Stock may be entitled, the rights of holders of shares of such series of Preferred Stock in the event of liquidation, dissolution or winding up of the affairs of this corporation, the rights of holders of shares of such series of Preferred Stock to convert or exchange shares of such series of Preferred Stock for shares of any other capital stock or for any other securities, property or assets of this corporation, and whether or not the shares of such series of Preferred Stock shall be redeemable and, if so, the term and conditions of such redemption.”
Definition of Liquidation
Since the main focus of this article is the liquidation preference, we will not discuss the other potential preferences which can included in a series of preferred stock. As for liquidation, I usually include a paragraph like the following so that the holders of the preferred stock are aware of, and in agreement with the definition of a liquidation event.
“As used herein, the term “Liquidation” shall be deemed to consist of any liquidation, dissolution or winding up of the corporation, whether voluntary or involuntary, a consolidation or merger of the corporation into or with any other entity or entities which results in the exchange of outstanding shares of the corporation for securities or other consideration issued or paid or caused to be issued or paid by any such other entity or affiliate thereof (other than a merger to reincorporate the corporation in a different jurisdiction) in which the shareholders of the corporation do not continue to hold at least a 50% interest in the successor entity, a transaction or series of transactions that results in the transfer of more than 50% of the voting power of the corporation and the sale, lease, abandonment, transfer or other disposition by the corporation of all or substantially all its assets.”
Examples of how Participating and Nonparticipating Preferred Stock Provisions Work
Assume now that the Board has made a deal with an investor (or investors) to issue 100,000 shares of preferred stock. The Board may designate 100,000 out of the 1,000,000 shares as a separate series. For the moment, let’s call it Series A Participating Preferred Stock. The rest of the class of preferred stock is “authorized but unissued” and is basically “in the bank” for future use (or not at all). Next, let’s assume that the investors put in $1 million, and the parties agree that this represents a 40% equity interest in the company. Now assume that there is a liquidation preference that says the following:
“Liquidation.
In the event of a liquidation, dissolution or winding up of the Company, whether voluntary or involuntary (a “Liquidation”), the holders of the Series A Participating Preferred Stock then outstanding shall be entitled to receive out of the available assets of the Company, whether such assets are stated capital or surplus of any nature, an amount on such date equal to a per share amount of the Original Purchase Price (the “Liquidation Preference”). Such payment shall be made before any payment shall be made or any assets distributed to the holders of any class or series of the Common Stock or any other class or series of the Company’s capital stock ranking junior as to liquidation rights to the Series A Participating Preferred Stock. After the Liquidation Preference has been paid in full pursuant to this Section, the remaining assets (if any) of the Company available for distribution to stockholders of the Company shall be distributed, subject to the rights of the holders of shares of any other series of Preferred Stock ranking prior to the Common Stock as to distributions upon Liquidation, pro rata among (i) the holders of the then outstanding shares of Series A Participating Preferred Stock (as if the Series A Participating Preferred Stock had been converted into Common Stock as of the date immediately prior to the date fixed for determination of stockholders entitled to receive such distribution) and (ii) the holders of the Common Stock and any other shares of capital stock of the Company ranking on a parity with the Common Stock as to distributions upon Liquidation. If upon any Liquidation the assets available for payment of the Liquidation Preference are insufficient to permit the payment to the holders of the Series A Participating Preferred Stock of the full preferential amounts described in this paragraph, then all the remaining available assets shall be distributed among the holders of the then outstanding Series A Preferred Stock pro rata according to the number of then outstanding shares of Series A Participating Preferred Stock held by each holder thereof.”
The above paragraph means that the investors get all of their money back first, and then they split the leftover amount with the common stockholders on a 40/60 basis. Based on our assumptions, and the liquidation preference set forth above, here is what happens if the Company is sold for $3 million:
Preferred Investors – Liquidation Preference = $1,000,000
Preferred Investors – 40% Participation = $ 800,000
Common Stockholders – 60% Participation = $1,200,000
Outcome: Preferred Investors get $1,800,000 and common stockholders get $1,200,000.
Sometimes Preferred investors seek a multiple on the liquidation preference. What if the above liquidation preference paragraph says that the Preferred investors get “….. equal to a per share amount of two times the Original Purchase Price…”
Based on two times the liquidation preference set forth above, here is what happens if the Company is sold for that same $3 million:
Preferred Investors – Liquidation Preference = $2,000,000
Preferred Investors – 40% Participation = $ 400,000
Common Stockholders – 60% Participation = $ 600,000
Outcome: Preferred Investors get $2,400,000 and common stockholders get $600,000.
Management and all other common stockholders, always want to negotiate for nonparticipating preferred stock, and preferred stockholders always want participating preferred stock, for obvious reasons. So, let’s look at the same scenario with nonparticipating preferred stock and see how the proceeds get divided.
In a nonparticipating preferred stock scenario, the preferred stockholders have to evaluate which way they come out better. By that I mean that preferred stockholders either get their liquidation preference or they convert to common stock and take their pro rata share of the proceeds.
Based on two times the liquidation preference set forth above, in a nonparticipating preferred stock scenario, here is what happens if the Company is sold for that same $3 million:
Liquidation Method:
Preferred Investors – Liquidation Preference = $2,000,000
Common Stockholders = $1,000,000
Conversion Method:
Preferred Investors – 40% Participation = $1,200,000
Common Stockholders – 60% Participation = $1,800,000
In this case, the preferred stockholders will opt to maintain the liquidation preference and forego the conversion to common stock.
Conclusion
When negotiating with investors relating to preferred stock, be sure to run every scenario so that you fully understand the effect upon the common stockholders in a liquidation preference situation. Failure to calculate the variables can result in management and the other common stockholders coming up short upon the sale of the company.