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Introduction

Whisper it quietly, but at the advent of the new calendar year British entrepreneurialism and venture funding is in commendable health. UK start-ups and scale-ups raised record investment in 2020, closing $15bn in new venture capital, with the domestic technology scene in particular outperforming by virtue of raising more capital than its German and French equivalents combined.

At the seed end of the investment spectrum, there has been a surge in the number of new businesses being set up, with the Financial Times reporting prior to the holiday season that business incorporations were up 30 per cent in the four weeks to mid-December (year-on-year) as entrepreneurs sought to respond to the changing needs of a socially distanced world.

Meanwhile both on these shores and in the US it has already been well documented in the financial press that companies are choosing to remain private for longer. Series C rounds have seen consistent growth in the UK in recent years, both by deal count and total investment, as founders and their venture capital partners opt to fuel continued growth via late-stage private funding rounds rather than enter the public arena.

With this confluence of activity promising another strong slate of funding rounds in 2021, it’s important for both first-time founders and emerging fund managers to have a firm grasp of the liquidation preference, arguably the key economic provision in any growth company’s equity documentation.

Ordinary Shares v Preference Shares

A typical capital structure of a venture-backed company will feature at least two distinct classes of equity shares, ordinary shares and preference shares. The former class represents the true risk capital of the company and ranks at the foot of the ladder of priority between stakeholders. Holders of the ordinary shares can generally be identified as the founder(s), key employees if a share incentive scheme exists, and any angel investors or EIS/VCT fund managers (for reasons explained below).

The preference shares are held by the institutional investor(s) (the investor), be that a venture capital or private equity firm. They typically cost more but in return confer special rights on their holders, which may include any or all of the following; entitlement to a fixed (cumulative) dividend, the right to convert to ordinary shares, the right to redemption for cash, and/or the ability for the holders to “get their money back first” in the event of either a winding-up or sale of the company ahead of other shareholders. This last example is what is known as a liquidation preference.

 What is a liquidation preference and why have it?

The liquidation preference provision in its entirety sets out how a company’s surplus assets should be distributed between its shareholders on either a winding-up or a sale event. Surplus since, specific to a winding-up scenario, the company’s debts owing to its creditors (either secured or unsecured) must be settled first. It’s often referred to as a ‘waterfall’ provision by virtue of its clear order of distribution of proceeds from top to bottom.

The liquidation preference itself is the investor’s positioning at the top of that waterfall to ensure that where there are any proceeds remaining for shareholders they are able to recover some or all of their invested capital preferentially to the other shareholders.

Take for instance an example where a founder receives £2 million from an investor for 20% in her business (valuing the business at £10 million post-money). Without the liquidation preference in place, the founder could immediately sell her business for £5 million leaving the investor with half its money back and the founder pocketing £4 million in the process. A vanilla liquidation preference would ensure that in such an undesirable scenario, the investor would have a right to its £2 million back in priority to the founder receiving the remaining £3 million from the sale.

The detailed provision will almost always be located in a company’s articles of association near the top of the section that describes share capital rights. It’s of no consequence as to who actually holds the shares, hence why it’s unlikely to feature in any separate shareholders agreement between parties and first sight of the nature of the provision will be at the term sheet stage, given its importance. Ideally, the mechanism will be detailed in the term sheet. Tactically, it’s sometimes left rather high-level by the investor until after the term sheet has been signed.

To be clear, even though ‘liquidation preference’ (or “liquidity event”) is the common terminology used in both European and US transactions, the waterfall also usually applies to the distribution of proceeds at the time of a voluntary sale event – i.e. when proceeds are hopefully plenty and the shareholders as a group can share in the spoils in the proportions as calculated by the waterfall (but this time with more to go round). Despite the mechanism looking identical for both types of event, this upside position can be distinguished from a downside winding-up scenario in terms of the commercial bells and whistles which can be applied to the right by investors and also certain tax considerations, both of which is covered below.

Types of liquidation preference

The default position unless a liquidation preference has been negotiated is for capital proceeds at the time of a winding-up or a sale event to be distributed to all shareholders pro-rata to their respective shareholdings, on a per share held basis.

Liquidation preferences can then display the following characteristics, on a sliding scale of relatively investor-friendly to very investor-friendly (save for the last paragraph of this section):

Non-participating

Where an investor benefits from a non-participating liquidation preference, the result is that the investor will receive, in priority to others, a sum per share equal to its subscription price paid up plus any arrears of dividend owed on those shares by the company. The balance (if any) is then shared amongst the other shareholders proportionately. This type of preference offers the traditional downside protection for an investor in case the company’s valuation drops and is crystallised by a liquidity event post-investment, as exemplified above.

Participating

As the name suggests, a participating liquidation preference, confers on the investor a right to its money back first (on the basis described above) and then an additional entitlement to participate alongside the other shareholders in divvying up the balance of the proceeds between them proportionally.

It is in effect an opportunity for the investor to ‘double-dip’ at the expense of others. In addition to receiving a higher percentage of the company in the event of a winding-up or a fire sale event, the investor can also obtain more than its overall proportionate share of any proceeds in a lucrative sale event. The investor has downside protection and disproportionate upside in respect of its capital rights.

Multiples

Take the following as an example term sheet provision:

Investor X shall be entitled to a 2x participating liquidation preference

In this example, a multiple has been applied to the investor’s initial distribution preference with the result that rather than simply securing its initial investment amount from the proceeds first, the investor is entitled to twice that amount before the proceeds flow further down the waterfall (either on a participating or non-participating basis). One can apply the same simple logic for a 3x multiple, 4x multiple etc (although these are rarely encountered in practice).

Conversion Rights

A 1x non-participating liquidation preference generally remains the market standard for a funding round where diligence has not uncovered any red flags as to the company’s (or the sector in which it operates) future prospects.

To close the loop on types of liquidation preference, crucially even the 1x non-participating liquidation preference will normally be structured in a way that the investor can benefit from the higher of the amount it would receive were it to receive its initial distribution preference or the amount it would receive were it to participate shoulder-to-shoulder with all other shareholders. In this way, where a lucrative sale event has completed, the investor is not capped at its initial investment amount but can benefit from its full ownership percentage amount relative to the higher transaction value of the company as if it were an ordinary shareholder. Downside and (proportional) upside is covered off.

SEIS/EIS & VCT considerations

The explanation so far covers the standard position for VC/PE firms. So, what are the options or considerations for those individual or professional investors who take advantage of the popular SEIS/EIS (EIS) and VCT tax-efficient schemes? What, if any, restrictions are imposed on the use of a liquidation preference by those investors?

The basic rule for both EIS and VCT-funded investments is that there can be no liquidation preference over other shares on a winding-up event. This has always been the case. As a result, conventional preference shares are almost non-existent in UK angel and seed funding rounds (such rounds largely being the preserve of individual EIS investors).

Capital proceeds should thus be returned to all shareholders on a proportionate basis referable to the subscription price of their respective shares held and number of shares held.

So on a first pass, the tax legislation appears to deal a hammer blow to a liquidation preference for EIS and VCT investors (when dealing with a winding-up scenario).

One approach sometimes used in the market however has been the use of a ‘swivel’ arrangement as a means of the investor recovering its initial capital invested without necessarily benefitting from a preference in the eyes of HMRC. This is where the EIS or VCT investor takes 99:1 of all available proceeds in the first step of the waterfall until and up to the point at which they recover the cost of their investment, at which point the waterfall swivels onto the second step where the balance of proceeds is distribution in a mirrored ratio favourable to the other shareholders until they have ‘caught up’, at which point the remaining balance is often shared proportionally between all. Whilst this approach has been approved by HMRC on many occasions in the past, it is clearly not without risk and our recommendation would be that it is only deployed where an advance assurance in respect of the investment to be made has first been secured from HMRC.

However, swivel and also ratchet mechanisms which operate solely in respect of the balance of any surplus proceeds (once all shareholders “have got their money back”) have always been considered permissible by HMRC and so are sometimes used by fund managers.

Divisions of sale proceeds are not restricted in the same manner as for winding-up proceeds and that being the case EIS and VCT managers have a bit more freedom to express a more conventional priority right for such a scenario, with a 1x participating preference typically seen in the market.

Finally, it is prudent to always ensure that an express limiter is included alongside the waterfall where there is VCT investment being made so as to a return of more than 50% of the proceeds to the investor on a winding-up event. The effect being that the waterfall is not at risk of being in breach of the broadly-drafted VCT Independence Condition in the VCT rules.

In summary

So, with the influx of new recession-generated businesses to the market at one end of the spectrum and the prevalence of more mature businesses which are staying private for longer at the other, why is the correct deployment of the liquidation preference as important as ever?

Since the economic effect of an overtly investor-friendly liquidation preference can seriously jeopardise the delicate balance of equity interests between founders and the investors as a company scales through progressive funding rounds. As Fred Destin of Stride.VC remarked at the height of the first lockdown period last April:

“It’s easy to see how one round like this can be tough for founders, but it gets really grim when you consider the standard it sets. If each subsequent round asks for the same style of preference, the stacking effect can totally bury founders (as well as earlier preferred investors)”

This snowball effect of iterative deal terms is often set in motion by the first investor to ask for such a preference. Thus, by striking a balance early, both founders and early investors may both be better positioned come the time when the company needs its next injection of capital from a larger investor.

 

Ollie Blears

12 January 2021