Liquidation Priority under the CARE

Why worry about the Liquidation Priority?

In either a Dissolution Event or a Liquidity Event, both a CARE investor and a founder may be owed some money under the terms of their CARE and their shares, respectively.  The more important point, however, is whether they will actually receive what they are owed.

A CARE investor’s entitlement is explained in our articles on a Liquidity Event and a Dissolution Event.  A founder’s entitlement will depend entirely on the details of a Liquidity Event or, on a Dissolution Event, it would be a share of the company’s surplus assets (i.e. assets leftover after everyone else has been paid).  The investor and founder may be entitled to these amounts, but determining how much they will actually receive can get complicated.

If the company is liquidated – meaning a Dissolution Event is triggered – local laws would determine who gets paid and in what order.  There are usually special groups who get paid first, including the liquidators, the company’s employees, and the local government (e.g. for any tax), followed by any debtholders or creditors of the company.  The company’s shareholders would be the last in line for payment.

What does the Liquidation Priority do?

The question, then, is whether CARE investors should be treated as shareholders (even though they do not hold any shares) or as creditors (even though the company does not owe them any money).  Thankfully, the CARE answers this for us and sets out exactly how investors will be treated for payments on a Liquidity Event or a Dissolution Event.

In a Liquidity Event or Dissolution Event, CARE investors are effectively treated as shareholders – and not creditors – of the company.

This aligns with the investor’s motivation for entering into the CARE: to become a shareholder in the company.  Investors should ensure they understand the implications of this, as any payments they are entitled to on a Liquidity Event or Dissolution Event can only be made after all non-shareholders have been paid (including any non-converted convertible noteholders).

The CARE also sets an order of priority among CARE investors and shareholders.

For any Cash-Out Amount on a Liquidity Event, or repayment owed on a Dissolution Event, CARE investors and any preference shareholders are treated the same and rank ahead of ordinary shareholders.

For any Conversion Amount on a Liquidity Event, CARE investors are treated the same as ordinary shareholders and anyone else entitled to proceeds on an “as-converted basis“.

Anything else?

These terms of priority are mostly beyond the control of the investor, the company and the founder – and their impact, if any, depends on the amount of the available proceeds.  The key here is simply awareness; knowing these priorities exist and how they can impact CARE investors and shareholders alike.