Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process. In this series we’ll look to shed some light on the legal language contained in a financing term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both the Company and the Investor. Check out an overview here.
If dividends are the interest paid on a standard loan, then the “liquidation preference” is the return of principal. Together they form the economic spine of the stock (or other securities) sold to the Investor, and, as such, should be the primary focal point of negotiations related to the Company’s value.
Put simply, a “liquidation preference” is an amount of money which the Company agrees to pay to the holders of its preferred stock (or other securities being sold) prior to (or in “preference”) to all other funds it is to pay its other stockholders upon the Company’s sale (or “liquidation”).
Unlike in a standard bank loan, however, a “liquidation preference” can take many forms, some much more costly than others.
Because the “liquidation preference” concept is such an important one, both to the Investor (because it sets the baseline for determining the value of their shares in a “success” scenario) and the Company (as the founders are effectively agreeing to a certain amount of “overhang” on any sale of the Company before they themselves get paid), the NVCA model form expends a great deal of language on the idea. We will do the same.
The NVCA Language
In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:
Alternative 1 (non-participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred (or, if greater, the amount that the Series A Preferred would receive on an as-converted basis). The balance of any proceeds shall be distributed pro rata to holders of Common Stock.
Alternative 2 (full participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.
Alternative 3 (cap on Preferred Stock participation rights): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).
In addition, the model establishes the concept of a “Deemed Liquidation Event”, or set of circumstances which will be treated as a liquidation for purposes of the preference.
A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) and a sale, lease, transfer, exclusive license or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above [unless the holders of [___]% of the Series A Preferred elect otherwise].
The description of a “Deemed Liquidation Event” (as set forth in the model and ultimately in the Company’s Certificate of Incorporation) is relatively standard across transactions and not generally the subject of heated negotiation. That said, the concept is important to note on both sides, as it includes certain transactions (such as a license out of the Company’s assets) that some might not expect. In short, if a transaction would fundamentally change the operation or ownership of the Company it is likely to fall under the “Deemed Liquidation Event” concept, and, thus, liquidation preference will be owed.
Now let’s break down the “preference” terms themselves.
The Primary Preference
All three alternatives begin with the same baseline concept:
First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred.
The idea is simple enough. If the Company is liquidated (or if it experiences a Deemed Liquidation Event), the holders of preferred stock will receive an amount of money, generally based around multiples of their original investment, before any other equity holders are paid.
“Cheaper” money will cost only an amount equal to the original investment (or “1X” in the parlance), while more “expensive” money may cost two (“2X”) or three (“3X”) times such amount. Such “price” will be heavily negotiated by the parties based on market conditions, standard terms at the time, attractiveness of the Company and its products, and all the other usual factors that go into establishing relative leverage in a negotiation.
This one’s important folks.
(It’s worth noting that the bracketed dividend language included in the model is really a distinction without a difference as far as the liquidation preference concept itself is concerned. “Accrued” is simply the language used if cumulative dividends are to be paid (under the dividend term), while “declared” is the language to be used if non-cumulative dividends are to be paid. In both instances, dividends that are due and payable are to be included as part of the preference payment.)
“Participating” vs “Non-Participating”
It is in the second provision of each of the alternatives that there is conceptual separation.
In “Alternative 1”, after the preferred holders have been paid their preference:
The balance of any proceeds shall be distributed pro rata to holders of Common Stock.
By contrast, in “Alternative 2” (and “Alternative 3”):
Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.
In the language of a financing, Alternative 1 is “non-participating” while Alternatives 2 and 3 are “participating”. (This concept is usually included along with the baseline participation preference when parties discuss the economic terms of a proposed offering in shorthand. i.e., “1X participating preferred” or “2X non-participating preferred”).
“Participating” stock receives its initial preference, whatever it might be, and then gets to “participate” in the payments made to the common stockholders as if the stock had actually converted to common stock before the liquidating transaction. “Non-participating” stock is just the opposite. After a holder of non-participating stock has received its preference, they will receive no additional payment on their stock.
It’s worth noting that the language proposed to describe “non-participating” stock in the NVCA’s model actually includes an additional proviso stating that the non-participating stock will receive the greater of (i) the negotiated preference and (ii) the amount it would receive if it had converted to common stock (“…or, if greater, the amount that the Series A Preferred would receive on an as-converted basis…”). A couple of things to note here.
First, it is important to distinguish “non-participating” stock with such a feature (i.e. “automatic conversion”) from “participating” stock. Even with such language included, the “non-participating” holder receives only one of the preference or the common participation, never both. The “participating” holder receives both payments. “Participating” stock is always more expensive.
Second, strictly speaking the additional language is wholly unnecessary. Preferred stock always has the right to convert to common stock whenever it wishes. If a liquidating transaction results in proceeds to the Company that would result in a “non-participating” holder receiving more as a common stock holder, then they can convert before closing (and almost assuredly will).
Still, the language is often sought by both sides to help clear up any difficulties in determining final distributions when a liquidation occurs. With such language in place, the distributions to be made are simply mathematical (i.e., “higher number wins” and can be plugged into all relevant equations). Without such language, individual acts (such as conversions) cannot be simply assumed, so there is a certain amount of ambiguity until the deal is finally closed. As such a simple bit of language can otherwise resolve such ambiguity, and because it does not change the underlying economics involved, it is often included (as it is in the NVCA model).
The important thing to take away here is that “participating” preferred is a more expensive option than “non-participating” preferred, all other things being equal, but that the underlying primary preference can be as determinitive of the relative cost of the money to the Company. Said another way, “Is 1X participating preferred or 2X non-participating preferred the more expensive?”. The answer is unclear. It will depend on, among other things, the amount received in the liquidating transaction as well as the underlying capitalization of the Company. Because of that, the parties must consider both factors (and the possibilities of the future) when negotiating these terms.
Capped or Uncapped
The only difference between Alternatives 2 and 3 is in the notion of the “cap” on the amount the preferred can receive as part of their participation. The Alternative 3 holders get to receive their preference and participate as converted with the common stock holders “…until the [preferred] holders…receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).”
In this formulation, the notion is similar to Alternative 1’s flat 1X or 2X concept, but where Alternative 1 holders get to receive the entirety of their owed amount prior to (i.e., in “preference”) to the common stock holders, the Alternative 3 holders get only a portion in preference and then have to receive the remainder of such amount at the same rate paid to the common stockholders.
(Note that technically, a purely consistent set of terms would include under Alternative 3 the concept that the Alternative 3 holders would receive the greater of their capped amount and the amount they would receive had they converted, as the same logic applies here as it does in Alternative 1. Even the model form is not entirely consistent, however.)
Depending on the numbers at issue, then, Alternative 3 may actually be the cheapest of the alternatives from the Company’s perspective. Said another way, 2X non-participating preferred is more “expensive” than 1X participating preferred with a 2X cap. Obviously 1X non-participating preferred is not as expensive as 1X participating preferred regardless of the cap at issue, however, so as is always the case with economic terms the numbers really matter here.
The “liquidation preference” afforded to a class or series of stock (or other securities) is one of the most important terms to be negotiated by the parties. Though complex (and with myriad alternative formulations not described specifically in the NVCA models), it is important for both the Company and the Investor to intimately understand the implications of the preference agreed to before entering into definitive transaction documentation.
Throughout this series, I will be basing my discussion in part on the order and prominence of certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet. I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.
As always, if you’d like to discuss this post or your own company’s financing experiences please don’t hesitate to leave a comment down below or contact me at firstname.lastname@example.org.