Professional investors and founders always consider the possibility of the invested company’s dissolution, bankruptcy, or liquidation.
Every industry has a lifecycle. In a market with well-established brands, sticking to a business with little room for growth may not guarantee efficient capital utilization or a quick return on investment for the owners. This contrasts with first-time founders who often have a deep emotional attachment to their ventures.
Maintaining a competitive position is crucial for ensuring the continuous success and succession of experienced founders. Therefore, seasoned founders anticipate the potential end of their investments or business units and seek ways to minimize asset or equity loss.
To protect their assets, they often include anti-dilution or liquidation preference clauses in agreements, and may even calculate the potential for top-performing companies in their portfolio to offset underperforming ones. As long as the overall assets continue to grow at a rate higher than inflation, these strategies are considered effective.
1. The company’s valuation/market capitalization has decreased compared to the previous round (down round).
With the expectation that the invested funds will have an effect on the company within 3-6 quarters (i.e., 9-18 months), both founders and investors anticipate a higher valuation in the subsequent round. Unfortunately, due to various reasons, the company experienced a down round – a decrease in valuation.
Here are some hypothetical risks that could have occurred:
– Founders intentionally caused the company to lose money to reduce valuation.
– The majority investor group intentionally caused the company to lose money to reduce valuation.
– Due to unforeseeable events (natural disasters, epidemics, fires, etc.).
– The team was unable to execute the growth plan simply because the plan was beyond their capabilities.
As a result, a down round occurred.
Legal implications: The anti-dilution provision is triggered, and the conversion price of shares is calculated to compensate for the valuation gap.
We need to calculate the conversion price of shares using various financial techniques.
2. Situation of company dissolution or bankruptcy
In this case, the provisions to protect the company’s assets are activated.
A negotiated clause in a funding round requires the founders to return all or a significant portion of the investors’ investment (or a multiple of the total investment). For example, if investors invest 0.5 million USD, they will be refunded 2x Liquidation Amount ~ 1 Mil USD.
3. The company is acquired by a larger corporation, and the entire board of directors and executive management are replaced.
“Deemed liquidation” – A term often defined to include the merger, acquisition, change of control, or consolidation of a company, or the sale of all or substantially all of the company’s assets. Sometimes the term also includes an initial public offering (IPO) or a qualified disposition. In other words, the transaction form is a 100% buyout.
How to distribute the remaining funds:
- Pro-rata: The remaining proceeds are distributed proportionally, based on their ownership percentage, between preferred and common stockholders.
- Catch-up, then pro-rata: After paying the liquidation preference to preferred stockholders, common stockholders can “catch-up” by receiving an amount equal to the amount they originally paid or are deemed to have paid for their shares; and then the remaining amount is distributed proportionally among all shareholders.