Understanding Liquidation Preference in Part-Stock, Part-Cash Acquisition

In the world of mergers and acquisitions, liquidation preference can be a complex and nuanced topic. This is especially true when an acquisition includes both stock and cash components. While your term sheet might not explicitly address such a scenario, it's crucial to understand how liquidation preference works in these situations to ensure fairness and transparency.

Introduction to Liquidation Preference

Liquidation preference is a crucial term in equity financings that determines the order in which different classes of stockholders are paid off during a company's liquidation. This preference can significantly impact the value received by different stakeholders, particularly in the event of a company sale or liquidation.

Handling Part-Stock, Part-Cash Acquisitions

When an acquisition includes both stock and cash, the liquidation preference must be clearly defined. Without a specific amendment in place, the terms of the original agreement may not fully cover this scenario. However, experienced management teams and investors often anticipate such situations and ensure that the exit strategy is fair and transparent for all parties involved.

Case Study: Instagram's Explosive Growth

Consider the example of Instagram, which rapidly gained 40 million users within a short period. In anticipation of such a significant exit, the investor pool and management team would have discussed and agreed upon a scenario where part of the consideration would be in the form of stock, while the remainder would be in cash. This agreement typically requires a specific resolution or amendment to the original term sheet.

In such a case, the preferred stockholders would be entitled to a predetermined amount of cash before any common stockholders or later series of preferred stockholders. The specific split, such as 40% cash and 60% stock, would be agreed upon and documented.

Cash-Based vs. Stock-Based Acquisitions

Typically, each individual share of a company's preferred stock will be converted into a cash/share split during an acquisition. For example, if a company agrees to pay $12.00 per share, with $4.00 per share in cash and $8.00 per share in stock, unconverted preferred stockholders will receive all the proceeds until their liquidation preference is met.

It's important to note that the liquidation preference ensures that preferred stockholders receive a specified amount of cash before common stockholders or other series of preferred stockholders can claim their share. This process is crucial for maintaining the intended hierarchy of debt and equity holders during liquidation.

Exercising Liquidation Preference in Early-Stage Investing

In some cases, the earliest investors may have included clauses that give them the right to liquidate assets before the common stockholders or later-stage preferred stockholders. These clauses, known as preemptive rights, can provide early investors with a more favorable exit scenario.

While liquidation preference is critical, it's essential to maintain transparency and fairness throughout the process. All investors and stakeholders should exit in the most equitable manner, ensuring that the original agreements are honored and that no party is unfairly treated.

Conclusion

Liquidation preference plays a pivotal role in the acquisition process, especially when stock and cash are involved. By understanding and properly addressing these dynamics, stakeholders can ensure a smooth and equitable exit. Transparency and fairness should remain at the forefront of all discussions to protect the interests of all parties involved.