prefereds vs. commons in escrow payments
Note:
Found this quite interesting, since there is still uncertainty
about escrow benefits p vs u,
about 75-25 probably not any more.... or still for some....
about rights of class change ( underwriter ), etc.
...when to decide pro preferred or pro common, when to convert,
who, why,...and this in the legal framework that was valid before 2012,
explained here....do not know, if it helps.
The liquidation preference of Non-Participating Preferred
What is "the deal" with the NVCA escrow clause?
Jonathan D. Gworek.....February 15, 2007
Recently introduced wording options in the model bylaws prepared by the Drafting Committee of the National Venture Capital Association (the "NVCA") have generated
a lively discussion among legal practitioners and venture capitalists.
The discussion revolves around a very fundamental question.
What does a liquidation preference entitle
non-participating preferred shareholders to in the event of a liquidity event?
As discussed below, the choice of different design options with respect to escrow and other contingent payments can result in a very different distribution of proceeds in certain liquidity events.
The specific type of liquidity event for which these design options are relevant is one in which the consideration paid to all stockholders at the closing does not exceed the amount that the preferred stockholders would elect to receive upon conversion into common stock
(this amount is hereinafter referred to as the "conversion threshold"),
but in which there is an escrow or other contingent payment
which, if subsequently released, would result in an aggregate consideration to shareholders that would exceed the Conversion Threshold.
In this scenario, the preferred shareholders are not certain at the time of closing,
whether it is better for them to receive their original investment back as a senior payment
or to be treated as holders of ordinary shares
and share in the proceeds, including any contingent payments,
alongside the common shareholders.
The specific NVCA formulation option at issue eliminates the need for preferred stockholders to make a choice between these two options at closing and ensures that they will ultimately receive the greater of the two amounts.
In the event of a liquidity event, holders of non-participating preferred stock will be entitled to receive, on a per share basis, the greater of:
(1) the original price per share paid for the preferred stock plus any accrued but unpaid dividends (hereinafter referred to as the "Liquidation Preference"),
or
(2) the amount that the holder would receive if its preferred stock were converted into common stock.
When most liquidity events occur, this decision is relatively easy to make:
If the total consideration payable to all shareholders is above a certain amount, preferred shareholders are better off being treated as if they had been
converted into common stock,
since investors will always receive more than their liquidation preference
on an "as converted" basis.
Conversely, preferred shareholders are better off if the total amount of consideration payable to all shareholders is less than a certain amount, as they will then receive their liquidation preference.
While the above scenarios are relatively straightforward, the decision becomes more complicated for holders of Series A Preferred Stock,
if the total consideration payable exceeds the $10 million conversion threshold,
but a portion of it is contingent and payable in the future pursuant to an escrow agreement,
an earn-out or other retention so that less than the $10 million conversion
threshold is paid at the time of closing
Preferred stockholders do not know at the time of closing, when the first payment is made, whether they are better off taking their liquidation preference or being treated a
s if they had converted to common stock because they will not know whether the total consideration exceeds the conversion threshold until the contingent payment is made (or not).
For example, if the total consideration is $15 million, but only $5 million is payable
at closing and the balance of $10 million is payable pursuant to an earn-out, holders
of preferred stock face a dilemma....
A new wording option in the NVCA documents relieves holders of Series A Preferred Stock from this predicament.
This option provides that the preferred stockholders will receive their initial $5 million as if they had elected the liquidation preference,
and then, when the earn-out is paid, the preferred shareholders receive
an additional $2.5 million.
This leaves them in the same position at closing as they would have been had they elected to be treated as if they had been converted to common stock.
This option allows the preferred stockholders, until the trust agreement is terminated, to "
ride two horses" until the trust agreement is terminated, by first being treated as preferred shareholders and then moving to receive the consideration payable to common shareholders,
if this turns out to be the better outcome for them once the contingent payments
have been made.
Using this mechanism, the preferred shares retain the characteristics of common shares and preferred shares until the contingent payment is made. In this way, the drafting option transforms the preferred stock into a security that is a "hybrid" of preferred and common stock.
The introduction of this drafting option has led practitioners to focus their drafting efforts on the question,
which of these approaches leads to the right result for the preferred and common shareholders.
Reasonable people can and do argue about which is the right outcome. Of course, if investors were acting in their own self-interest, they would lean
argue for the "hybrid" approach, while common shareholders would believe that preferred shareholders must choose at the time of the initial closing whether to take their liquidation preference and nothing else, or to be treated like
common shareholders and share equally in both the initial payment and the escrow risk.
In an attempt to shed light on this discussion, the commentary to the NVCA documents indicates that the "most common" approach in practice is to require preferred shareholders to choose one or the other.
This result also seems consistent with the history of how the mechanics of the liquidation preference regime have evolved. The original (and until not long ago more common) drafting approach left little doubt on this point. Under that earlier approach, holders of preferred stock actually had to convert their preferred stock into common stock prior to the completion of the sale of the company if they wished to participate
as if they were a common stockholder. If they did not do so, they remained preferred shareholders at the time of the closing of the sale and, as such, were entitled only to their liquidation preference. If the holders of preferred stock converted to
common stock prior to a liquidity event, they would effectively be
common stockholders and would be paid out as such, sharing fully in any escrow risk.
A more recent approach taken in the NVCA model forms eliminates the need for holders of preferred stock to actually convert to common stock and instead allows them to be treated as if they had converted. This so-called "deemed" conversion was introduced,
in part, to simplify the closing mechanisms by eliminating the need for actual conversion
of preferred stock into common stock. However, this mechanical approach was not intended to change the economics of the distribution upon a sale of the company by allowing holders of preferred stock to benefit from the "hybrid" approach described above.
Conclusion
The real question is:
What did the parties agree to as the transaction?
The problem, and the source of much confusion, is that this subtle attribution point,
although it has far-reaching implications,
is typically not addressed in the term sheet.
Given that practitioners generally agree that the conventional approach is the more common and accepted meaning of the term "non-participating preferred stock,"
it seems reasonable for those negotiating term sheets for venture capital to explicitly state that,
if the parties have agreed and intend that holders of preferred stock will have the benefit of "hybrid" non-participating preferred stock. The explicit mention
in the term sheet would avoid many unnecessary negotiations during
the drafting phase of the transaction and
of the transaction and save time and money for all parties involved.
If this point is not explicitly mentioned in the term sheet,
the non-participating preferred shares should be interpreted
to have the usual meaning.
www.morse.law/news/liquidation-preference
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