Liquidation Preferences: A Legal And Business Concern

Posted on April 13, 2011

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A recent article in the Birmingham Business Journal (BBJ) announced the sale of a Birmingham-based company which produces a diagnostic test targeted to particular patients. While the sale (which reportedly carried a price tag in the $25-100 million price range) seems like a huge boon to both the company and the area, it may come as a surprise that not all shareholders in the company will benefit equally and some are discovering their long-held investments are worthless.

“Liquidation Preference” is the term to describe the concept of the amount per share that a holder of a given series of Preferred Stock will receive prior to distribution of amounts to holders of other series of Preferred Stock or Common Stock. It is the liquidation preference which can result in different groups of investors receiving different returns when a company is sold or otherwise liquidated. A liquidation preference is often a required term of venture-backed investments.

However, problems can occur when there are multiple financing rounds and each financing adds a new preference. According to VC Experts, “There may be multiple layers of Liquidation Preferences as different groups of investors buy shares in different series. For example, holders of Series B Preferred Stock may be entitled to receive 3X their Issue Price, and then if any money is left, holders of Series A Preferred Stock may be entitled to received 2X their Issue Price and then holders of Common Stock receive whatever is left.” It can be thought of as a cascading waterfall with each investment round “catching” a defined return. It’s easy to imagine that by the time the cash proceeds of a sale are caught by so many buckets, there can be nothing left for the common shareholders, which often include founders, their friends and family, and others who were early backers of a company.

In the case of the local company, it was reported that holders of the Series A Preferred and common stock stand to receive nothing from the sale proceeds. The BBJ reports that, “An anonymous source familiar with the buyout said private investors who put in up to $100,000 in the early stages … were also left out.”

Liquidation Preference raises issues in both the legal and business realm.

If you are a business owner or investor in a company that has received multiple equity financings, it is important to remember that while a buyout offer might seem like a great financial reward for your investment, it is not necessarily the case. Once buyout money is used to pay off debt and the liquidation preference of the preferred stockholders, certain shareholders can be left out in the cold. This is why it is so important to engage competent financial advisors and legal counsel early in any sales process of your company.

Furthermore, a recent ruling in Delaware Chancery Court calls into question the standards by which the decision to sell or liquidate is made, adding a layer of legal complexity to a dynamic that is already challenging.

Prior to this recent decision, it was accepted that the board of directors of a company could approve a sale of the company based on the “business judgment” rule. This means there is a legal presumption that the board is acting in good faith and their actions are not subject to judicial review. This would appear to give the directors elected by venture capital investors, assuming they constitute a majority of the board, the right to approve the sale of a company, even if the aggregate liquidation preference of the preferred stock would consume the entire proceeds of the sale. That is to say, the benefactors of the liquidation preference — the providers of later-stage financing — could approve a sale in which no proceeds flow down to the common shareholders.

In the case of In Re Trados Incorporated Shareholder Litigation, a common stockholder alleged a breach of fiduciary duty by the directors and questioned their decision to merge the company at a time when only stockholders holding shares with a liquidation preference and management would receive a share of the proceeds. According to the claim, “A common stockholder alleged that the company was a viable business, the common stockholders would have been able to secure consideration for their shares in a future transaction had the merger not occurred and that the interests of the common and preferred stockholders diverged over the board decision to pursue an immediate sale of the company …”

The common stockholders argued that the directors affiliated with the venture funds, that stood to benefit directly from the liquidation preference, could not exercise independent and disinterested business judgment and the Delaware court was unwilling to dismiss the claims of the common stockholder. The significance of the case is that courts, when presented with similar facts, may hold directors to the “entire fairness” standard rather than the more deferential “business judgment” standard. Such a change would put the burden on the board members to prove the transaction is fair to the common stockholders, a far greater task than under the business judgment standard.    

This is an evolving area of the law and it remains to be seen how these standards will be applied to future business sales and what, if any, litigation will result from said sales. We will keep you posted as these issues develop.

John Steiner
Steiner Law, LLC

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