Investors will usually want to get their investment monies back ahead of the founders in the case of an ‘exit’ – meaning a share sale, a sale of all of the assets, an IPO or a winding-up of the company. This is known as a ‘liquidation preference’.
In larger series A rounds with VC and non-EIS fund investors, investment is usually made by Preferred Shares which provides for this liquidation preference and often certain other rights over Ordinary Shares. Preferred Shares are so called because they have preferred rights over Ordinary Shares.
Preferred Shares are, however, almost non-existent in UK angel and seed funding rounds, which are dominated by EIS and SEIS investors.
This is because under the EIS/SEIS rules, shares must not have ‘any present or future preferential rights to a company’s assets on a winding up’ in order to qualify for tax relief.
The shares issued for EIS/SEIS investment must also be ordinary, non-redeemable shares, fully paid in cash at the time of subscription.
Liquidation preference on a share sale is allowed
The EIS rules do allow shares which have preferred rights over the proceeds received from a third party buyer of the shares in the company. The shares which have such rights are often called ‘A Ordinary Shares’.
In a share sale, A Ordinary Shares give investors:
the right to recover an amount up to to their original investment in the company
but the remaining proceeds are distributed among the holders of the Ordinary Shares (usually the founders), and not the holders of the A Ordinary Shares
as alternative, the right to convert their A Ordinary Shares into Ordinary Shares and be paid a proportion of the proceeds based on their equity ownership of the company along with other holders of the Ordinary Shares.
For example, if an investor invests £1 million in A Ordinary Shares for 20% ownership and the company is subsequently sold for £2 million, the investor is likely to want to receive their £1 million investment back under the liquidation preference, rather than convert into the Ordinary Shares for 20% of £2 million (i.e. £400,000). The investor will only be indifferent as to which option to exercise, if the sale price is £5 million (also known as the conversion threshold). A sale price below the conversion threshold would encourage the investor to exercise the liquidation preference. A sale price above the conversion threshold would encourage the investor to convert their A Ordinary Shares into Ordinary Shares.
What happens if the company sell all of the assets?
On sale of all the assets, the sale proceeds will be held by the company. Investors holding the A Ordinary Shares will only receive the sale proceeds based on their equity ownership if the company decides to pay dividends or wind-up.
Investors should have control over the process as the investment agreement will normally prohibit sale of all the assets of the company without their consent.
What happens in an IPO?
On an IPO, the A Ordinary Shares will usually be automatically converted into Ordinary Shares, so that investors participate in the IPO as any other holders of Ordinary Shares.
On a winding-up of the company?
In the event of a return of capital on winding-up, investors holding the A Ordinary Shares will simply be paid a proportion of the proceeds based on their equity ownership of the company along with holders of the Ordinary Shares.
Investors should have control over the process as the investment agreement will normally prohibit winding-up of the company without their consent.
There is, however, a continuing review of case law and HMRC guidance on whether A Ordinary Shares could be paid ahead of the Ordinary Shares on a winding-up (i.e. contain a liquidation preference in relation to a winding-up) and still comply with the EIS/SEIS rules. There is a suggestion that A Ordinary Shares could still comply provided each class of shares participates to some extent at each payment stage of a winding-up (e.g. 99% to A Ordinary Shares and 1% to Ordinary Shares). Founders may want to consider offering liquidation preference for winding-up on this basis to EIS/SEIS investors.
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