Understanding the Implications of a Startup Liquidity Event on Preferred Shareholders
A startup liquidity event, such as an acquisition, can have significant implications for the preferred shareholders of the company. In this article, we will explore the specific scenario where a liquidity event involves a purchase from Investor B 70 of the total shares, and how this affects Investor A, who holds 5% ownership, without exercising Tag-along or Right of First Refusal (RoFR).
Change of Control Provision and Liquidation Preference
The transaction will likely trigger a Change of Control provision, which allows the entire class of preferred shareholders to demand their liquidation preference payment in cash.
Liquidation Preference is the amount invested by the preferred shareholder, plus interest, in a simple preferred stock structure. It does not necessarily relate to the actual value of the company. If the stock is worth more than the liquidation preference amount, the preferred shareholders may choose not to demand the payment under this provision.
In a participating preferred stock structure, in addition to receiving cash, holders will also receive a number of shares of common stock. This means that if the preferred shareholders do not exercise their rights, the terms of their securities remain unchanged, but there is now a new majority owner of the company.
A Private Stock Sale and Investor Rights
A one-to-one sale of shares of a private venture-funded U.S. company by an existing stockholder to a new owner generally would not give rise to a liquidation preference for any of the preferred stockholders. This is because such a transaction does not qualify as a relevant Corporate Event that triggers the preference in the investment documents of those stockholders.
Specifically, a Corporate Transaction Event is normally defined as one of the following: (1) the company selling or divesting most or all of its assets, (2) a merger or consolidation with another company that results in a change of voting control, or (3) issuing new stock in a way that causes a change in voting control. A private stock sale does not fit into these definitions but often triggers other investor rights, such as Right of Co-Sale (Tag-along) and Right of First Refusal (RoFR).
Other investor rights, such as fiduciary duties, require the buyer, seller, board of directors, and any company representatives approving or facilitating the sale to treat all shareholders equally and fairly.
No Exercise of Rights: What Happens Next?
If an investor, such as Investor A, does not exercise any of their rights, nothing changes. The terms of their security remain the same. However, now there is a new majority owner of the company.
It is worth noting that in general, if an investor was properly notified of the transaction and declined to exercise their rights at that time, they have no grounds to complain after the fact. In some cases, they might find a legal flaw in the circumstances of the transaction, how it occurred, or how they were notified.
It's important to understand that each specific transaction is unique. The outcome would depend on the exact sequence of events and the detailed terms of all the relevant documents, as well as interpretations of applicable state and federal corporate and securities laws. As such, anyone in a similar situation should seek advice from a competent corporate lawyer.
Understanding the implications of a startup liquidity event, Change of Control provisions, and the action or inaction of Preferred Shareholders is crucial for all parties involved in the transaction. Proper legal guidance can ensure that all rights and obligations are clearly understood and respected, allowing for a smooth and successful transaction.