Liquidation Preferences (IIa) - Sub-optimal liquidity events

DISCLAIMER: The methods presented in this article are not hard-and-fast rules for payout calculations. These are suggestions based on the Svested team’s decades of experience assisting hundreds of companies with their CapTable calculations.  In addition, the scenarios presented here are solely for the purpose of illustrating our payout calculation methods, and may not exactly reflect the scenarios companies deal with in real-life liquidity events.

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Introduction

Following on from our previous article on liquidation payouts, in the 9th article of our CapTable series today, we discuss sub-optimal payout scenarios, and how they look like on a payout table.  For founders who have not done as well in growing their business, it may be necessary to prepare for such payout scenarios as eventualities.  At the same time, this article will touch on liquidation seniority, including pari passu, which is often used when there are insufficient funds to pay out all investors.

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As per what we highlighted previously, however, much like CapTable updating, payout simulations should be done using dedicated CapTable management software, in order to reduce the incidence of mistakes, as well as to improve efficiency.  This is a feature which Svested is looking to build into our platform, as there is currently no good solution in the market.

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Liquidation Seniority explained

Liquidation seniority determines which preference shareholders (or tranche of preference shareholders) get paid out first.  Most startups follow a standard liquidation seniority, whereby its newest preference shareholders (or latest-round investors) get paid out first, followed by investors from earlier fundraising rounds.  

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For instance, a company’s Series B investors must first receive their minimum payout, before Series A investors get anything.  Similarly, Series A investors must receive their payout first, before Seed investors get anything.

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There are, however, a few other types of liquidation seniority.  Pari passu seniority is where all tranches of preferred shareholders end up having the same level of seniority – that is, they will each receive a cut of the company’s proceeds from its exit or liquidation, no matter how early or late their investment was made.  Though uncommon, investors sometimes will offer pari passu as a sweetener for founders, especially those involved in “hot” deals. 

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The most common method by which preferred shareholders are paid out, under pari passu, is by proportion of funds contributed, relative to the total amount that is contributed by its preferred shareholders.  The other key method would be simply by percentage shareholdings.

Last but not least, tiered liquidation seniority combines both standard andpari passu liquidation seniorities. For companies with multiple fundraising rounds and sub-rounds. (E.g. Series A0, A1, A2, A3, A4, etc…) The incoming investor may want to clean up the captable or simplify the liquidation preference stack. As such, they may request that some of the rounds be grouped into tiers, and the tiers are paid out in order. However, within each tier, investors receive payouts on a pari passu basis.

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Scenario setup

Similar to last week’s article, we have Company Y, whose CapTable is shown below.  Company Y has:

• 2 founders, who invested $500 and $400, with a price per share of $0.001
• 3 Seed investors, who received a price per share of $2.50
• 3 Series A investors, who received a price per share of $4.50
• The total investment received by the company is $7,695,900
• All preferred shareholders have invested based on a 1⨉ non-participating liquidation preference, with the liquidation payout based on amount invested

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The company is now about to undergo an trade sale, and is receiving a sum of $5,000,000 from the acquisition deal – a sub-optimal deal scenario.

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Payouts by pari passu liquidation seniority

First, let us consider the case where Company Y adopts pari passu liquidation seniority.  In this case, ALL its preferred shareholders are treated as equal, and will each receive a cut of the funds from the trade sale, prorated according to the proportion of funds contributed relative to the total funds contributed by preferred shareholders.

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The payout table is shown below:

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The proportion of funds contributed for each preferred shareholder is calculated by: 

Individual funds contributed / Total funds contributed by preferred shareholders.  Note that because there are insufficient funds to pay out the investors, by default, common shareholders (the founders and ESOP holders) do not receive any payout – that is, the founders’ investments are not factored into the pro-rata calculations.

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Once the proportion of funds contributed is calculated, we simply take each percentage value and multiply it by $5,000,000 (the funds received by Company Y from its trade sale) to get the payout amount.  Lastly, we divide the payout amount by the original investment again to obtain the payout multiple.

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Notice that in the case of pari passu, which means “equal consideration” for all preferred shareholders, their payout multiples are also all exactly the same, at 0.65.  There is technically another way to find out the payout multiple for all investors, if pari passu is used: simply take the funds obtained from the liquidity event, and divide it by the total funds contributed by the preferred shareholders.  In this case, we have:

5,000,000 / 7,695,900 = 0.649697 ≈ 0.65, which is the same as what we have calculated in the payout table.

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Payouts by standard liquidation seniority

By standard liquidation seniority, the latest-round investors of a company get paid first, before earlier investors receive any funds.  In Company Y’s case, Investors F, G and H – its Series A shareholders – must be paid first, before other preferred shareholders receive anything.  

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However, the scenario we have presented in this article is tricky: according to the liquidation preferences of Company Y’s Series A investors, the minimum payout to be received is $5,445,000.  In this case, Company Y does not even have sufficient funds to fully pay out even its Series A investors.

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Because of this, what happens is: (1) Company Y’s Seed and Common shareholders are excluded from the payouts, receiving $0; (2) Company Y’s Series A shareholders are paid out based on either (a) their relative percentage shareholdings (within the round) or (b) proportion of funds contributed (within the round as well).  In essence, pari passu will be applied within just the Series A investors.

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The corresponding payout table for (a) their relative percentage shareholdings is shown below:

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In this case, the payout for each Series A investor is calculated by their relative percentage shareholdings, which is given by: Number of shares held / Total number of Series A shares.  Given that all 3 Series A investors received the same price per share on their investment, the calculated relative percentage shareholdings for each investor would be the same as the proportion of funds contributed (within only the Series A round).

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Once the relative percentage shareholdings are calculated, it is then simple to obtain the total payout and payout multiple.  The total payout is determined by taking the relative percentage shareholdings for each investor, and multiplying that by $5,000,000 – the total funds received by Company Y from its trade sale.  The payout multiple is calculated the same way – by taking the total payout, and dividing that by the original investment.

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Notice again that because the Series A investors received the same price per share, correspondingly, their payout multiple is also the same across the board.

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The corresponding payout table for (b) proportion of funds contributed is shown below:

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For this payout method, the proportion of funds held (relative to the total raised in Series A) is multiplied by the deal amount of $5,000,000 to get the final payout.  For instance, for Investor F, the payout amount is given by: $1,485,000 / (1,485,000 + 1,710,000 + 2,250,000) ⨉ $5,000,000 = $1,363,636.

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Note that for this calculation method, all Series A investors receive the same amount as the relative percentage shareholdings method.  This is due to the absence of any convertible instruments such as Simple Agreement For Future Equity (SAFE) or Convertible Notes (CN) and/or combination of rounds into a single liquidation pack. 

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If, on the other hand, Company Y has received a slightly better deal of say, $6,000,000, then Company Y will be able to pay out its Series A investors according to their 1⨉ non-participating liquidation preference, while its Series Seed investors will be given a partial payout.

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Limitations of this article’s analysis

• A company’s CapTable might, in reality, be far more complicated than shown in this article
• All investors considered in this article are priced round investors with the same price per share in each round – in reality, a company may have one or more noteholders, who received a different price per share for the round they participated in.  Should this be the case, there is a need to be careful about the liquidation payout formula
• When a payout is sub-optimal, but enough to cover at least 2 tranches of investors, depending on the investors’ liquidation preferences, different payout scenarios will have to be run (for instance, if the investors have a non-participating liquidation preference, and can choose to either receive shares by percentage shareholdings, or by liquidation preference)

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Conclusion

Liquidation payouts in sub-optimal liquidity events or deals can vary greatly. If the company is undergoing acqui-hire, then some equity will have to be carved out for the founders in order for the deal to make sense.  Sub-optimal liquidity events can sometimes also be considered as a rescue deal or an honourable exit. 

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For pari passu payouts, all preferred shareholders are given equal consideration, and will each receive a portion of the funds received by the company.  On the other hand, if a standard liquidation seniority is used, then there may be 1 or more tranches of investors who do not receive their payouts at all.  If funds are insufficient to pay out a specific tranche of investors, then within that tranche, investors receive their payouts by their percentage shareholdings, or on a pari passu basis.

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