Introduction
Thelma’s Tacos Incorporation is a private company in the restaurant industry. The company is planning to raise $10 million by issuing preferred stock to a company named Food Ventures. This is a limited liability company. Food Ventures is a venture capital company in a series B round of financing. Bob Robson who recently graduated from a school of law represents Thelma’s Tacos Incorporation in negotiating the financial transactions. In these negotiations he works with a food venture’s counsel, Abigail Adam. An agreement has not been reached on a few issues and more in depth analysis need to be conducted.
The first unresolved issue relates to the investors’ liquidation preference. An agreement to a 2X liquidation preference has been reached although it has not been agreed if it will be participating preferred. Abigail is of the opinion that her clients would prefer full participation. She says that they may agree to a cap only if it’s high enough. Abigail also adds that a definition of liquidation to state if it includes mergers, consolidations or any other business combination is necessary.
Bob does not understand Abigail’s point of view. He doesn’t understand some of the terms Abigail uses. He therefore attempts to change the subject to move to a conversation that he feels more comfortable. He starts a topic on preferred stock holders and says that they should ensure that they don’t infringe the rights of these stock holders. This makes Abigail realize that she did not check the protective provisions of the series A holders and their rights. She then asks Bob if he can check the protective provisions. Bob agrees even though he doesn’t understand what protective provisions are. Abigail then checks if there are preemptive rights for series A holders in the company’s certificate. The certificate clearly indicates that each holder of a series A preferred shall have a right to maintain a proportionate ownership if this is acceptable by law.
This means that depending on the investment an investor invests in a company, he/she is given a particular number of shares to represent the percentage of the company that he/she owns. This is important when it comes to the returns which the investor gains. Owning a larger proportion of the company means that the dividends of the investor will be more as opposed to those who posses fewer number of shares and hence a smaller portion of the company. Bob thanks Abigail for agreeing to give his clients an anti-dilution protection. This entitles them to maintaining their ownership percentage even when the company issues more stock but Abigail says that she should be the one thanking him for having the opportunity to work with him.
Bob realizes that he has taken on a project which he cannot handle. He consults a special legal consultant and asks for advice regarding all the unresolved issues. The task is to help Bob understand about the issues and give recommendations on how to resolve them. This will ensure that Bob is decisive enough and makes the right choice. The choice should be to the best interest of his clients.
Explanations
There were disagreements in various topics during the negotiations between Bob and Abigail. These topics are discussed here to give more insight on what they entail and how they should be handled. Liquidation preference is used to protect the investment of the investors. It directs that if a company is dissolved or the company’s assets are sold, then the preferred stock holders are paid a given amount of money first before the other common share holders are paid their money (Constance and Craig, 2008).
The amount the preferred stock holders receive is equal to the amount they had initially invested. In addition to this amount, they may also be paid the amount owed to them by the company. This may include dividends. Liquidation preference gives the preferred share holders a flexibility to convert to common stock from liquidation preference. This mainly occurs if the company is to be liquidated for an amount that is more than their investment. It ensures that the preferred stockholders get returns equivalent to their percentage of ownership as opposed to their liquidation preference which would otherwise be lower. Liquidation preference would also include any accrued and unpaid dividends. A 2X liquidation preference means that the preferred stock holders will receive twice the amount of the original purchase price per share as their liquidation amount per share.
Participating preferred liquidation is a concept of liquidation preference. Constance and Craig (2008, pg. 454) explain that “if an investor holds participating preferred stock, then after the preferred stock is paid its liquidation preference, it receives, in addition, its pro rata share of what remains as though the preferred stock had converted to common stock. If preferred stock is not participating, all proceeds in excess of the liquidation preference would go to the common share holders”. This will be considered if after the conversion of the preferred stock to common stock, the preferred stock holders get less returns compared to the other common stock holders.
The common stock holders receive returns that outweigh their investment. Participating preferred liquidation recommends that the preferred stock holders are subjected to both their liquidation preference and in addition to that, they are also given the chance to also participate in the common stock share. This however is arguable. The holders of the common stock are involved directly in ensuring the company grows and improve its revenue yet the liquidation policy dictates that they receive less return.
To help solve this situation, introduction of a cap to the liquidation preference is necessary. A cap is an upper limit which should not be exceeded. It is the maximum permissible value and any acceptable value must be below it. In the U.S, the cap is set to an amount that is two or three times the amount of the preferred stock holders’ original investment (Constance and Craig, 2008). This ensures that the preferred stock holders are not entitled to returns that are above the capped value. If such a situation arises, then the preferred stock holders will not be subjected to the liquidation preference but would only convert their stock to common stock.
They will then receive their returns on a pro rata basis. The application of this situation is therefore dependent on the success of the company. If the company is more successful, the capping comes into effect. On the other hand, if company is not successful, the preferred stock holders are not subjected to conversion of their stock to common stock. This flexibility in the conversion of preferred stock to common stock should be controlled. This is made possible by capping.
Full participation preferred means that the preferred stock holders will have the flexibility and therefore gain considerable returns depending on the success of the company. Setting the cap to a very high value is not recommended since it only favors the preferred stock holders while at the same time resulting in minimal returns for the common stock holders.
The example below may be used to indicate the importance of capping. Consider that Food Ventures invests the $10 million for a 45% stake in Thelma’s Tacos Incorporation. After a period of twenty years the company is valued at $25 million. If the company is liquidated then the preferred stock holders will get a return of $10 million if they stick to their liquidation preference. On the other hand, if they choose to convert to common stock and abandon their liquidation preference they will get a return of $11.25. This value obtained after abandoning their preferred stock is more than that obtained if they stick to their liquidation preference.
Therefore the investors will take the option of converting to common stock since its returns are more compared to choosing the liquidation preference. The common stock holders will therefore get $8.75 million to divide amongst themselves. On the other hand, if participating preferred is considered, then the investors will get the $10 million they had invested in the company and in addition to this they will also be subjected to another 45% of the remaining $10 million value of the company.
This means that in total they will end up getting $14.5 million. The common stock holders will be left with $5.5 million to share amongst themselves. From these figures it is evident that if we consider participating preferred, the preferred stock holders may end up gaining more returns at the expense of the common stock holders. This illustrates the importance of capping and ensuring that the value of the cap is not too large. This enables the common stock holders to also benefit incase of liquidation or selling of the company.
A merger is where two companies combine and results in the formation of a single company. One of the companies is considered to be disappearing while the remaining company is considered to survive. The surviving company inherits the assets, liabilities and assumes all the rights of the disappearing company. The decision to form a merger rest entirely on the majority share holders. This prevents the minority share holders from preventing any transaction that may take place prior to the merger. When a merger has been established, the preferred stock holders still have the liquidation preference incase the resultant company goes to liquidation.
A merger should mutually benefit both companies that have agreed to establish it. It should not in any way favor one company as opposed to the other. Proper negotiations on the preferences and the privileges in which the share holders will be subjected to once the merger has been formed should be discussed in depth before the formation is finalized. This ensures that the facts are well documented and no party will complain of unfairness once the transaction is completed. During a merger, the status of the stock holders should be maintained. This also ensures that there is no conflict once the transactions have been finalized. Some of the conflicts may include the preferred stock holders no longer having this status after the formation of the merger.
Protective provision requires that the preferred shared holders are informed before certain decisions in the company are made. This mainly takes place if the preferred stock holders remain the majority share holders. The decisions include;
- Trying to change the rights, preferences or privileges of the preferred stock holders.
- Trying to either increase or decrease the recommended number of shares owned by the preferred stock holders or the common stock holders.
- Creating a series of shares that will have more rights, preferences or privileges that are more than those owned by the preferred stock holders.
- Performing any action that will result in the acquisition of the company or the sale of part of it (Constance and Craig, 2008).
This means that before any of the above activities are carried out, the consent of the series A stock holders must be sorted. Failure to do so results in the amendments not being implemented. The protective provisions ensure the smooth running of the company and eliminate the problem of conflict of interest.
Series A holders enjoy various rights and preferences. They have the liquidation preferences where they have the right to convert their stock. This enables them to convert their preferred stock to common stock at will. In addition, automatic conversion benefits are accorded to them. In this case, their stock can be converted to common stock automatically. They also have anti-dilution provision which ensures that they are protected incase the stock is split. This provision means that they will remain with their actual investment even after the split. This is achieved by ensuring that the number of their shares is increased to ensure that their percentage of ownership remains intact. Some of the other rights they posses include voting rights, rights of first refusal, right to information and registration rights (Constance and Craig, 2008). These rights give them an element of protection and the power to be decisive in the company.
Recommendations
Bob should agree to a full participating preference. However, the cap should not be set to a large in order to also consider the returns the common stock holders will get. If the value of the cap is too high, then the preferred stock holders will have a wide range of flexibility thus limiting the returns of the common stock holders in the event that the company is liquidated. This will give the preferred stockholders an unfair advantage over the common stock holders who are involved in the improvement and development of the company. Bob should therefore convince Abigail to tell her clients about the necessity of the cap. This will not make them lose their investments but will serve to take care of the common stock holders who are directly involved in the running of the company.
Since the liquidation preferences are still considered when a merger has been established, Bob should ensure that the definition of liquidation does not include a merger, consolidation or any other business combination. This is because accepting to such terms will mean that the company gets to pay its preferred stock holders if a merger is established. This means that after the merger is formed, the surviving company will not have the benefits of increased investment from the disappearing company since its returns will have to be paid to its stock holders. This will be a hindering factor if the company wants to merge with another company.
The consent of Series A holders is needs to be acquired before any major decision involving the company is made. This is important in the running of the company as new directives pass through enough scrutiny before decisions are made. It also ensures that wide consultations are made before changing the company’s policies. This gives confidence to the investors as they are involved directly in decision making. Participating in critical decision making improves the confidence of the investors in the running of the company. Bob should ensure that all the rights of the series A holders are observed. They should always be respected to ensure mutual and productive relationship between different parties in the company.
Conclusion
Bob should consider the recommendations given to ensure that the decisions he makes will be to the best interest of both parties and most importantly his clients. The unresolved topics are also well explained. This will ensure that Bob gets a clear view of what he did not understand while talking to the counsel of Food Ventures. Decision making should not be done in a hurry. It should be done after careful consideration of the recommendations given. This is because once an agreement between Thelma’s Tacos Incorporation and food ventures is reached and the papers are signed, it may be impractical to reverse the terms of the agreement.
Reference
Constance, E & Craig, E 2008, The Entrepreneur’s Guide to Business Law, Westgroup Press, Ohio.