Liquidation Proceeds Exercise—A Mature Company’s Founders

Liquidation Proceeds Exercise—A mature company’s founders and investors are considering several harvest proposals

Liquidation Proceeds Exercise—A mature company’s founders and investors are considering several harvest proposals. The company was founded in March 2011 with $200,000 in founder funds and $300,000 in family loans (8% interest annual interest accrued & due @ HARVEST). The company raised $2,000,000 from a Shark Tank Investor in March 2013. The Shark owns 1,000,000 shares of 6% cumulative dividend, participating convertible Preferred Stock, on which no dividends have been paid. The Shark’s interest represents a 45% equity interest in the company. The Shark’s Preferred Stock Investment is subject to a 3 X proceeds CAP; and has a 1.5 X Liquidation Preference. One buyer has proposed to purchase all equity in the firm for a net payment amount of $11,000,000. How will the $11,000,000 be distributed if the Shark does not convert the Preferred Stock (meaning she EXERCISES the Liquidation Preference)? (Think about what must be paid out of the proceeds before equity stakes are calculated and divided). Family Lenders Get: Shark gets: Founder gets: What annualized return will the founder have earned if this deal is accepted; and proceeds are distributed in March 2016?

Paper For Above instruction

The scenario presents a mature company with a complex capital structure and various stakeholders—including founders, family lenders, and a significant investor, referred to as the Shark. The primary task involves analyzing the distribution of proceeds from a proposed sale of the company, particularly focusing on how the $11 million purchase price will be allocated under specific liquidation and dividend preferences. Additionally, the exercise asks for an evaluation of the founder’s annualized return based on the distribution timeline and proceeds.

Company Background and Capital Structure

The company was founded in March 2011 with initial funds from the founders and family loans. Specifically, the founders contributed $200,000, and the family loans amounted to $300,000 with an 8% annual interest rate, accruing and due at the time of liquidation (“HARVEST”). In March 2013, the firm secured a substantial investment of $2 million from a Shark Tank investor (the Shark). The Shark’s investment was in the form of preferred stock, consisting of 1,000,000 shares of 6% cumulative dividend, participating convertible preferred stock. Notably, no dividends have been paid on this preferred stock to date, and the preferred shares grant the Shark a 45% equity stake in the company.

Key Features of the Preferred Stock

• Participation: The preferred stock is participating, meaning the shareholder can receive dividends or proceeds both as a preferred and common equity.
• Dividend Rate: Cumulative at 6%; dividends accrue annually and are payable before any distributions to common shareholders.
• Liquidation Preference: The preferred stock has a 1.5x liquidation preference, indicating that the preferred shareholders will receive 1.5 times their original investment or the amount specified before proceeds are distributed to common shareholders.
• Proceeds Cap: The preferred stock is subject to a 3x proceeds cap, limiting the total payout to the preferred shareholders relative to their original investment.

Distribution of Proceeds Under the Proposed Sale

The buyout proposal offers a total of $11 million for all equity in the firm. To determine how this amount is distributed, especially when the Shark does not convert her preferred shares, the preference and cap provisions must be considered first.

Step 1: Calculate the Liquidation Preference for the Shark

The original investment from the Shark was $2 million. The 1.5x liquidation preference means the Shark is entitled to 1.5 times her original investment, equating to $3 million. However, the proceeds cap of 3x on her investment limits the claim to three times the investment, or $6 million. Since $3 million is less than the cap of $6 million, the Shark’s liquidation preference would be $3 million.

Step 2: Allocate the Sale Proceeds

Out of the $11 million, the first payment must cover the Shark’s liquidation preference of $3 million. After paying the Shark, remaining proceeds amount to $8 million ($11 million – $3 million).

Step 3: Distribute Remaining Funds

Next, the founders and family lenders are typically paid after satisfying the preferred shareholders’ liquidation preferences, depending on the terms of their loans and any contractual agreement. The family loans, totaling $300,000 with accrued 8% interest, are a priority debt, so they should be paid next, amounting to:

• Principal: $300,000
• Accrued interest: 8% per year from 2011 to 2016 (approximately 5 years). The interest accrued is $300,000 x 8% x 5 = $120,000.
• Total family lender payout: $420,000.

Subtracting this amount from the remaining proceeds yields $7.58 million ($8 million – $420,000).

Step 4: Distribution to Founders and Remaining Stakeholders

After satisfying the preferred and family debt, the remaining proceeds can be divided among the equity holders, including the founders. The preferred stock’s participation feature allows the shareholder to partake in the residual after their preference is paid, but since she is exercising her liquidation preference without converting, she does not participate further at this stage.

The remaining $7.58 million is to be distributed based on ownership stakes. The Shark owns 45%, and the remaining 55% is split among founders and other shareholders. Typically, the founders’ shares comprise a significant portion, with specifics depending on prior arrangements. Assuming that the equity distribution reflects the ownership structure at the time, the remaining proceeds would be divided proportionally.

Distribution Calculation:

• The Shark, having exercised only her liquidation preference, will not receive additional payment beyond the $3 million, as her participation is capped and she is not converting her preferred stock into common.
• The founders and other shareholders will share the residual proceeds based on their ownership stakes after the preferred shareholders are paid.

For simplicity, if the founders and other shareholders hold the remaining 55% of equity, they will collectively receive the residual amount of approximately $7.58 million. Specific individual distributions depend on their ownership ratios.

Founder’s Return Calculation

To compute the founder’s annualized return, we consider the initial investment and the distribution schedule. The founders initially invested $200,000 in March 2011, and proceeds are distributed in March 2016, giving a five-year investment period.

The total proceeds attributable to the founders would be a portion of the residual funds. Assuming they share equally in the 55% residual ownership, the founders would receive approximately 55% of the $7.58 million, equaling about $4.169 million.

The return on the founders’ initial $200,000 investment over five years is calculated using the compound annual growth rate (CAGR):

\[

\text{CAGR} = \left(\frac{\text{Final Amount}}{\text{Initial Investment}}\right)^{1/5} - 1

\]

Substituting values:

\[

\left(\frac{4,169,000}{200,000}\right)^{1/5} - 1 \approx (20.845)^{0.2} - 1 \approx 1.764 - 1 = 0.764

\]

or about 76.4% annualized return.

Conclusion

In summary, when the company is sold for $11 million, the liquidation proceeds are allocated first to satisfy the Shark's liquidation preference of $3 million, up to the cap, after which family loans totaling $420,000 are paid. The remaining proceeds are distributed among the founders and other shareholders based on ownership. The founders' annualized return, based on their initial $200,000 investment and the residual proceeds, approximates 76.4% over five years.

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