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“Liquidation Preferences” in a Fund-Raising Round – What to watch out for?

When a start-up raises funds from investors, especially from venture capital and private equity firms, one of the hotly contested items in the term sheet will be the liquidation preference clause.

What is liquidation preference?

The term ‘liquidation preference’ is not a term used in the Malaysian Companies Act 2016. Instead, the legal basis for ‘liquidation preferences’ originates from s90(4), which requires that where preference shares are issued, the constitution shall set out the “rights of the shareholders with respect to repayment of capital, participation in surplus assets and profits…and priority of payment of capital….in relation to other shares of other classes of preference shares.”

Investopedia provides a helpful overview on the definition of liquidation preference, which is reproduced below:

“The liquidation preference is a clause in a contract that dictates the payout order in case of a corporate liquidation. Typically, the company’s investors or preferred stockholders get their money back first, ahead of other kinds of stockholders or holders of debt, in the event that the company must be liquidated.”[1]

Let’s break down the definition:

“corporate liquidation”

Liquidation preference typically only kicks in, in the event the investee company (i.e. the company receiving investments) is undergoing or has undergone a “liquidation event”. It is a common misconception that ‘liquidation events’ are limited to only situations when the company is shut down, wound-up, dissolved or ceases to exist, which is often not the case, as it really depends on how the agreement defines ‘liquidation events’. Instead, the term ‘liquidity events’ in fundraising documentation are often defined to capture different forms of ‘exit events’ for the investors.

Some non-exhaustive examples of liquidation events can include:

  1. Where the investee company is liquidated or dissolved;
  2. Where the shares (often a majority or more) of an investee company is acquired by another party;
  3. Where the assets (often a majority or more) of the investee company are sold;
  4. When more than 50% of the shares with voting rights in the investee company is sold (bearing in mind that some companies issue preference shares without voting rights); OR
  5. When the company lists on a defined stock exchange (which may be controversial to treat as a liquidity event to some founders, who may view an IPO as just another fundraising round).
“preferred stockholders”

A liquidation preference is a right attached to preference shares issued to investors of the investee company. Ordinary shareholders, by default, do not have such preferences.

“payout order”

This means which party will be paid out of the proceeds of a liquidation event first.

“ahead of other kinds of stockholders or holders of debt”

The payout order will be that preference shareholders get paid first out of the proceeds of the liquidation event, and ordinary shareholders (typically founders of start-ups and early stage angel investors are usually ordinary shareholders) will only be paid out of the remainder of the proceeds.

This begs the question, how much of their investment do investors get back?

How much do investors get back?

A liquidation preference clause can be drafted in a myriad of ways in the term sheet. However, keen attention should be paid to:

  • What multiple of the investment amount will an investor get back? This is usually represented in the term sheet as “1x, 2x up to 3x of the investment amount”, which represents the multiple of the investment amount which the investor will be entitled to receive in a liquidation event ahead of or in priority to other shareholders. For example, if the liquidation preference grants a multiplication of 1x, an investor who has invested MYR 3 million in the investee company, will be paid MYR 3 million x 1 from the available proceeds of the liquidation event. If the multiplication is 2x, an investor will receive MYR 3 million x 2, or MYR 6 million, so on and so forth. Where there are insufficient proceeds or surplus to fully meet the liquidation preference payout, the other shareholders will end up with nothing.
  • After investors receive the multiple of their investment amount, will investors be allowed to split the remainder of the proceeds based on their proportion of shares? This is usually represented by the words “participating” or “non-participating”. For example, an investor who has invested MYR 3 million into the investee company with the liquidation preference of “1x, participating” for 10 percent of shares in the investee company. In a liquidation event, the proceeds of the liquidation event is MYR 9 million. The investor will receive:
    • Firstly, the MYR 3 million x 1; and
    • Thereafter, 10% of the remaining MYR 6 million, from the investor’s 10% shareholding proportion in the investee company, being MYR 600k.

On the other hand, if the liquidation preference is “1x, non-participating”, the investor’s entitlement will only stop at MYR 3 million x 1, and the ordinary shareholders will split the remainder of the proceeds of MYR 6 million based on their shareholding proportion.

In early rounds (Pre-Seed to Series A), investors may request for participating or non-participating. Non-participating is more beneficial to the ordinary shareholders, and as such negotiations should begin on the basis of non-participating, especially where the preference shares come attached with a right to convert such preference shares into ordinary shares, which is another topic on its own.

Conclusion

As we can observe from the above, liquidation preferences may seem harmless to the founder where each investor understandably wants some ‘downside protection’ to recoup its investment amount. However, do bear in mind that the definition of liquidation events is necessarily not confined to a winding-up of the business, and where the company goes through several rounds of fundraising, founders may end up with little or nothing with poorly negotiated liquidated preferences, even in a successful buyout / exit event.

Due attention should be paid when negotiating the liquidation preference clause, to ensure both start-ups, founders, and investors can walk away from the negotiating table with a win-win resolution.

[1] https://www.investopedia.com/terms/l/liquidation-preference.asp#:~:targetText=The%20liquidation%20preference%20determines%20who%20gets%20paid%20first%20and%20how,of%20holders%20of%20common%20stock.

***

This article was written by Shawn Ho (Partner) & Ian Liew (Associate) from the corporate practice group of Donovan & Ho.  Shawn leads the corporate practice group of Donovan & Ho, and has been recognised as a Notable Practitioner, whilst the firm has been recognised as a Notable Firm for Corporate and M&A by Asialaw Profiles 2020.  We are also ranked as a Recommended Firm by IFLR1000 2020.

Our corporate practice group advises on corporate acquisitions, restructuring exercises, joint venture arrangements, shareholder agreements, employee share options and franchise businesses, Malaysia start-up founders and can assist with venture capital funds in Seed, Series A & B funding rounds. Feel free to contact us if you have any queries.

 

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