All You Need to Know About the Company Liquidation Process

It's natural to have unanswered questions regarding what happens during a corporate liquidation. A corporation may wonder what this entails and why it must go through this process. The goal of a company's liquidation is to pay off its debts, hence the name "liquidation." This definition aims to describe what it is and why it occurs in a broad sense. A company can be forced into liquidation or go into it voluntarily. In the former, a creditor or other interested party files a petition with the court asking for the company to be liquidated so that its debts can be settled in full.

Forcible dissolution

Filing for a liquidation target isn't a quick fix for paying off your obligations. Instead, the petitioner must show that all other means of compensation have been tried and that the only remaining option is for the corporation to dissolve. Typical causes of bankruptcy include failure to pay obligations as they come due, inability to liquidate assets to cover responsibilities, or tax debt. The business is handed over to a receiver and a liquidator. Next, they'll start the process of determining the worth of the company's assets and selling them off individually.

A voluntary winding down of operations

In most cases, this form of liquidation is less stressful for all parties involved. That's because the company's directors are the ones responsible for planning and carrying out the entire operation. Without the interference of the courts, the process of liquidating firm assets and winding down can be considerably more rewarding for all parties concerned. The company's failure to make a profit, or to ever make a profit, or the company's failure to register as required by law are all valid grounds for initiating a voluntary liquidation. When liquidation appears to be the only option for the company, voluntary liquidation is often used as a preventative step to avoid being forced into liquidation.

If you don't need to liquidate, then why would you

Liquidation is the process through which a corporation is dissolved and its debts are settled in full while creditors are compensated. Directors may be required to make personal contributions to satisfying company debts. However, there are rare cases where directors may be held personally liable for the company's obligations. This is especially true if the director willfully causes the company to incur excessive debt. Trading while insolvent and failing to take corrective measures are examples of such conduct. Instead of waiting until the firm is forced to close down, a director can decrease litigation risk by engaging an insolvency agency to handle the entire process voluntarily.

All That Glitters Is Not Gold: Startup Valuations And The Liquidation Preference Overhang

JUST THE FACTS

First, we'll discuss how venture capitalists (VCs) typically finance new businesses. There is already a lot written online about venture capital, so we'll only focus on the parts that are relevant to the bankruptcy cloud. Preferred stock, as opposed to common equity, is what a venture capitalist will receive (the latter usually by way of options). To put it simply, preferred stock is stock whose holders are granted privileges beyond those granted to common stockholders. For a venture capitalist, the liquidation preference is almost as crucial as the investment price (or value).

In the event of a liquidation, the VC will get payment in accordance with the liquidation preference. Liquidation, for these reasons, encompasses not only the negative (such as bankruptcy), but also the positive (such as a merger, acquisition, or sale of practically all of the company's assets), outcomes in which shareholders receive compensation for their shares. If the firm were to be sold, the VC investor would receive their share of the proceeds before the holders of common stock due to the priority they have over them.

A one-to-one (or "1x") multiple is the industry norm for liquidation preference, which indicates that in the case of a liquidity event, the VC investor will receive its entire initial investment back before common stockholders (i.e., employees) receive any proceeds. If a venture capitalist (VC) invests $10 million with a 1x liquidation preference, the VC will receive the first $10 million in proceeds from any liquidity event.

When a liquidity event happens, VC investors can either take the liquidation preference or convert their preferred shares to common shares so that they can take part in the distribution as common stockholders. They will choose the one that will bring in the most cash.

Investors in private equity (VCs) have valid reasons to expect a liquidation preference. When they invest millions of dollars in a startup, they take on a lot of risks and have every right to want to safeguard their capital. Most of the other owners are "sweat" equity, while the VCs are writing the huge checks the company needs to develop, so the liquidation preference provides downside protection to the VCs to get their investment back.

IN WHAT WAYS DOES THIS AFFECT WORKERS?

The term "overhang" describes this situation. When a company's valuation falls below the total amount of outside funding provided by VCs, a "liquidation preference overhang" becomes a factor. Let's clarify things using an illustration. After five years of service at the same company, during which time your stock options are fully vested, you learn that the company will soon be sold for $50 million. Assume that the company has raised $40 million from venture capitalists for an 80% ownership, that the founders each own 10%, and that you and the other employees each own 10%.

The VCs would get their $40 million back with a 1x liquidation preference, and the founders and workers would split the remaining $10 million proportionally. If this were to happen, both the company's founders and employees would each receive $5 million. However, keep in mind that the VCs might choose to take their liquidation preference or convert their preferred shares into common shares to partake in the liquidation proceeds as holders of ordinary stock. Given that 80% of $50 million is $40 million, the VC would not care whether the company took the liquidation preference or converted to common (assuming preferred stockholders did not receive dividends).

Suppose now that the company is being sold for $40,000,000. Without the VCs taking their liquidation preference, the company's founders and workers would lose their $40 million investment. Instead of getting $40 million ($40 million *.8) by converting to common stock, the VCs would be better off taking their liquidation preference.

SO, WHAT CAN WORKERS DO?

The unvarnished truth is that not much if any, can be said to satisfy this question. The workforce as a whole does not have enough sway to affect decisions about how much and what kind of venture capital funding the company should accept. We totally realize that the thought of taking a pay cut to work for a startup, being compensated mostly in illiquid company stock, and then having your equity potentially be worthless even if the firm is sold for many millions of dollars scares the living daylights out of you is a valid one.

An employee's best course of action is to complete their research about the company and the position thoroughly before accepting it. The amount of venture money invested in the company is another "smart" topic for a prospective employee to ask during salary negotiations (CrunchBase or AngelList may also have this information, but you will get more reliable information directly from the company). You can get a ballpark estimate of value by asking the questions we've suggested in the past. Find out how much venture capital funding the company has received so you can get a well-informed opinion regarding the potential for an overhang situation.

It's not all bad news. The initial investment required to launch a successful tech startup has decreased. As a result, there is less of a need for extra funding, and consequently, there is less of a risk of an overhang.