Liquidation preference

Last updated

A liquidation preference is one of the primary economic terms of a venture finance investment in a private company. The term describes how various investors' claims on dividends or on other distributions are queued and covered. Liquidation preference establishes that certain investors receive their investment money back first before other company owners in the event the company is sold, has a public offering, pays dividends, or has another liquidation (payout) event. [1]

Contents

Types

Liquidation preferences can be partial (they apply to less than 100% of investment funds), full (100%), or at a multiple of original investment funds. Further, interest or guaranteed dividends may or may not be added to the preference amount over time. Occasionally the multiple shifts over time as well.[ citation needed ]

Another distinction is that preferences may be "participating", meaning investors receive their preference first and are then entitled to a share of any remaining funds based on their ownership, or they may be "non-participating", in which case they receive either their preference amount only with no further right to distributions, or else their proportionate share of distributions but without the preference, whichever is greater. [2] For instance:

Participating liquidation preference: As an example, an investor invested $1M in a $6M pre-money valuation ($7M post) with a 2x participating liquidation preference. They would then own 14.4% ($1M/$7M) of the company and would get upside on any change of control. If the company then sold for $15M the investor would get back 2x of their investment first for $2M (2 × $1M) and then the rest of the remaining $13M ($15M – $2M) would be distributed among all shareholders. The investor would then get an additional $1.9M (14.4% × $13M) for a total of $3.9M ($2M + $1.9M). [3]

Non-Participating liquidation preference: As another example using the same numbers as above, the investor has a 2x non-participating liquidation preference and a 14.4% ownership of a $7M post-money valuation. If the company again sold for $15M, the investor would have a choice of either receiving $2M (2 × $1M) for their liquidation preference or $2.2M (14.4% × $15M) for their participation. Thus the investor would then receive $2.2M. [4]

Preferred stock

Liquidation preferences are typically implemented by making them an attribute that attaches to preferred stock that investors purchase in exchange for their investment. This means that the preference is senior to holders of common shares (and possibly other series of preferred stock), but junior to a company's debts and secured obligations. There are several types of liquidation preferences related to preferred stock. [5]

See also

Related Research Articles

<span class="mw-page-title-main">Dividend</span> Payment made by a corporation to its shareholders, usually as a distribution of profits

A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-invested in the business. The current year profit as well as the retained earnings of previous years are available for distribution; a corporation is usually prohibited from paying a dividend out of its capital. Distribution to shareholders may be in cash or, if the corporation has a dividend reinvestment plan, the amount can be paid by the issue of further shares or by share repurchase. In some cases, the distribution may be of assets.

<span class="mw-page-title-main">Equity (finance)</span> Ownership of property reduced by its liabilities

In finance, equity is an ownership interest in property that may be offset by debts or other liabilities. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets owned. For example, if someone owns a car worth $24,000 and owes $10,000 on the loan used to buy the car, the difference of $14,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business. A business that needs to start up or expand its operations can sell its equity in order to raise cash that does not have to be repaid on a set schedule.

A shareholder of corporate stock refers to an individual or legal entity that is registered by the corporation as the legal owner of shares of the share capital of a public or private corporation. Shareholders may be referred to as members of a corporation. A person or legal entity becomes a shareholder in a corporation when their name and other details are entered in the corporation's register of shareholders or members, and unless required by law the corporation is not required or permitted to enquire as to the beneficial ownership of the shares. A corporation generally cannot own shares of itself.

<span class="mw-page-title-main">Warrant (finance)</span> Security that entitles the holder to buy stock

In finance, a warrant is a security that entitles the holder to buy or sell stock, typically the stock of the issuing company, at a fixed price called the exercise price.

In finance, a convertible bond, convertible note, or convertible debt is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.

Preferred stock is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.

Common stock is a form of corporate equity ownership, a type of security. The terms voting share and ordinary share are also used frequently outside of the United States. They are known as equity shares or ordinary shares in the UK and other Commonwealth realms. This type of share gives the stockholder the right to share in the profits of the company, and to vote on matters of corporate policy and the composition of the members of the board of directors.

<span class="mw-page-title-main">Employee stock option</span> Complex call option on the common stock of a company, granted by the company to an employee

Employee stock options (ESO) is a label that refers to compensation contracts between an employer and an employee that carries some characteristics of financial options.

In economics and accounting, the cost of capital is the cost of a company's funds, or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

<span class="mw-page-title-main">Share (finance)</span> Unit of equity ownership in the capital stock of a corporation

In financial markets, a share is a unit of equity ownership in the capital stock of a corporation, and can refer to units of mutual funds, limited partnerships, and real estate investment trusts. Share capital refers to all of the shares of an enterprise. The owner of shares in a company is a shareholder of the corporation. A share is an indivisible unit of capital, expressing the ownership relationship between the company and the shareholder. The denominated value of a share is its face value, and the total of the face value of issued shares represent the capital of a company, which may not reflect the market value of those shares.

Post-money valuation is a way of expressing the value of a company after an investment has been made. This value is equal to the sum of the pre-money valuation and the amount of new equity.

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing to pay or receive to effect a sale of the business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest.

<span class="mw-page-title-main">Participating preferred stock</span>

Participating preferred stock is preferred stock that provides a specific dividend that is paid before any dividends are paid to common stock holders, and that takes precedence over common stock in the event of a liquidation. This form of financing is used by private equity investors and venture capital (VC) firms. Holders of participating preferred stock have the choice between two payoffs: a liquidation preference or an optional conversion. In a liquidation, they first get their money back at the original purchase price, the balance of any proceeds is then shared between common and participating preferred stock as though all convertible stock was converted. In an optional conversion, all shares are converted into common stock. Holders of participating preferred stock will always pick the option with the highest payoff.

The following outline is provided as an overview of and topical guide to finance:

A reverse convertible security or convertible security is a short-term note linked to an underlying stock. The security offers a steady stream of income due to the payment of a high coupon rate. In addition, at maturity the owner will receive either 100% of the par value or, if the stock value falls, a predetermined number of shares of the underlying stock. In the context of structured product, a reverse convertible can be linked to an equity index or a basket of indices. In such case, the capital repayment at maturity is cash settled, either 100% of principal, or less if the underlying index falls conditional on barrier is hit in the case of barrier reverse convertibles.

A venture round is a type of funding round used for venture capital financing, by which startup companies obtain investment, generally from venture capitalists and other institutional investors. The availability of venture funding is among the primary stimuli for the development of new companies and technologies.

In finance, a Class B share or Class C share is a designation for a share class of a common or preferred stock that typically has strengthened voting rights or other benefits compared to a Class A share that may have been created. The equity structure, or how many types of shares are offered, is determined by the corporate charter.

<span class="mw-page-title-main">Stock</span> Shares into which ownership of the corporation is divided

Stocks consist of all the shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporation in proportion to the total number of shares. This typically entitles the shareholder (stockholder) to that fraction of the company's earnings, proceeds from liquidation of assets, or voting power, often dividing these up in proportion to the amount of money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may be issued, for example, without voting rights, with enhanced voting rights, or with a certain priority to receive profits or liquidation proceeds before or after other classes of shareholders.

<span class="mw-page-title-main">Corporate finance</span> Framework for corporate funding, capital structure, and investments

Corporate finance is the area of finance that deals with the sources of funding, and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.

A simple agreement for future equity (SAFE) is an agreement between an investor and a company that provides rights to the investor for future equity in the company similar to a warrant, except without determining a specific price per share at the time of the initial investment. The SAFE investor receives the future shares when a priced round of investment or liquidity event occurs. SAFEs are intended to provide a simpler mechanism for startups to seek initial funding other than convertible notes.

References

  1. Nicholas Carlson (March 8, 2014). "Startup Employees Think They Are Going To Get Rich — Then A Horror Story Like This Happens". Business Insider.
  2. "Equity Release Calculator". 17 March 2022.
  3. "Liquidation preferences and employee options drastically affect valuation". alijavid.com. Retrieved 2017-09-21.
  4. "Liquidation preferences and employee options drastically affect valuation". alijavid.com. Retrieved 2017-09-21.
  5. WALKER, SCOTT EDWARD (16 August 2010). "Beware the trappings of liquidation preference". VentureBeat . venturebeat.com. Retrieved 21 October 2015.