Liquidation rights, also known as liquidation preferences, are a key element in contract negotiations for mergers and acquisitions. They determine who gets paid and when should a company choose to sell or liquidate all its assets.
With a merger, liquidation rights can be leveraged in the deal once the buyer figures out the breakdown of existing parties who need to get paid. For acquisitions, it’s all about properly allocating preferred stock and liquidation preferences to investors.
Liquidation Rights and Organizational Hierarchy
When a corporation is formed, it’s up to the board of directors to set up a stock structure that should include executive, preferred, and common stock. Each category awards the recipient with a certain number of votes per share and a place in the liquidation queue.
If venture capital is used for start-up money, the venture capital firm will typically insist that they be the first to get paid in the event of liquidation or sale of the company, ahead of debt holders or other preferred stockholders. Common stockholders get paid last.
Liquidation rights also come into play in the event of a bankruptcy. In this case, as in the case of a general liquidation or sale, a company liquidator needs to unwind the complexities of secured and unsecured debt, investor liquidation preferences, and preferred stockholder allocations.
It’s important to understand that the organizational hierarchy of liquidation rights can be very different from the executive or even board hierarchy of the company itself. General employees are typically issued common stock and can walk away with nothing in certain scenarios.
Liquidation Preference is a Key Element in MA Deals
Researching liquidation rights should be part of the due diligence process for any merger or acquisition. When there’s a change in ownership, certain obligations need to be attended to. Among those, there could be unresolved debt or repayments to investors.
This is one of those areas that bringing in an experienced MA consultant will pay dividends for you. In most cases, it’s the seller’s responsibility to meet repayment of debt obligations before closing the deal, but the buyer may inherit some of those liabilities if they are not careful.
Companies only need to sell 51% of their equity shares to transfer control to another business or private entity. The remaining shareholders keep their shares, some of which may be preferred stock that holds a liquidation preference. Your legal team needs to evaluate that.
Liquidation Rights for Preferred Stockholders
Issuing preferred stock to select investors or partners in the firm is not a guarantee of payment in the event of a sale or liquidation. It does, however, put them closer to the front of the line. Keep that in mind when structuring an acquisition contract.
To ensure liquidation rights are clearly defined, it is recommended that you utilize different classes of preferred stock. Callable shares, which can be bought out by the company prior to the next acquisition or merger, are a sensible option if investors will go for it.
Convertible preferred shares can be an attractive option also, and a good negotiating tool. They can be traded for common stock using a predetermined multiplier. Issuing these as part of an acquisition strategy can be a tradeoff for guaranteeing liquidation rights.
Classes of preferred stock to avoid when drafting an MA contract are participatory preferred shares and cumulative preferred shares. They each offer dividend guarantees, which can be a slippery slope. There are better ways to ensure major investors make a profit.
Liquidation Rights for Common Stockholders
Holders of common stock only benefit from liquidation rights when the acquisition price exceeds the sum of the guarantees made to preferred stockholders and any debt payments that need to be made before the deal can be closed.
Like preferred stock, common stock can be allocated into different classes, and liquidation rights can be assigned based on those classes. This is also how voting rights are awarded. When acquiring a new company, creating these classes is your responsibility.
When assigning common stock to employees, make sure there’s a reasonable vetting schedule in place to protect the company. If things don’t go well in the first few years and you have to sell, this will eliminate any liquidation rights for common stockholders.
Liquidation Preference for Founders with Capital Investment
A founder investing his or her own money into a company is not the same as a venture capital firm making an investment. Founders don’t have a special liquidation preference. They’re treated the same as any other preferred stockholder.
To alleviate concern over this, companies can create an “executive” class of preferred stock that has better voting rights and is higher up the chain for liquidation preference. This will usually guarantee some compensation after venture capital firms are paid.
Liquidation Rules for Creditors and Debt Holders
In cases of insolvency, there are rules for paying off creditors when a liquidation occurs. These don’t have to be included in an MA contract, but this list should be used when negotiating a purchase or sale. The following debts should be paid off in this order.
- Secured Creditors with a Fixed Charge
- Preferential Creditors
- Secured Creditors with a Floating Charge
- Unsecured Creditors
Fixed charges are assets used to secure a loan that have a fixed value, such as property or equipment. An example of a floating charge is stock, which fluctuates (floats) in value, but fixes on the liquidation date. Unsecured loans have no collateral attached and can be saved for last.
