Why have a Liquidity Event?
The CARE is used where an investor makes a cash investment on the expectation of receiving shares at a later date.
The aim may be for the investor to receive shares in the company (i.e. on an Equity Financing or, if applicable, a Maturity Conversion), but the CARE also covers instances where the investor will receive cash instead of shares. This can happen where things have gone wrong (see our article “Dissolution Events under the CARE“) or where things are going well.
This article focuses on what is (usually) a positive outcome for the company, its founders and investors: the occurrence of a ‘Liquidity Event‘. This happens where there is a change of control of the company, where it lists on a stock exchange, or where it sells a cryptocurrency or any digital tokens. Each of these events is more specifically defined under the CARE.
Let’s assume a company uses its CARE investment to successfully launch its product and start to drive significant sales. It could become an attractive target for acquisition. If a third party purchaser agrees to buy the company before it needs any more money (i.e. before it triggers an Equity Financing), this could be a windfall for the company’s shareholders. The purchaser would acquire all of the company’s shares and pay its shareholders for them. The CARE investor – who provided the critical financing that set the company on its path to success – would not be a shareholder at the time of sale (given their CARE would not have converted), meaning they could be left out from sharing in the success.
This is where the CARE’s Liquidity Event provisions kick-in to ensure the CARE investor rightly benefits.
What happens on a Liquidity Event?
If there is a Liquidity Event, the CARE investor is entitled to a portion of the proceeds. Exactly what they are entitled to – namely, the amount and type of proceeds – depends on the terms of the CARE and the kind of Liquidity Event.
Amount of proceeds
The investor will be entitled to either their ‘Cash-Out Amount‘ or their ‘Conversion Amount‘, whichever gives the investor more money. The Cash-Out Amount is based on the investor’s initial investment, whereas the Conversion Amount is based on what the investor would have received if their CARE had converted to shares as intended.
The Cash-Out Amount is easy enough to calculate: it’s the CARE investment amount multiplied by the ‘Multiple‘ agreed when negotiating the CARE. This is the only purpose of the Multiple. It sets a minimum return for the investor in a Liquidity Event. If the Multiple is 1, the investor is entitled to a return of their initial investment only and, if the Multiple is 2, it would be double their initial investment. There is no fixed figure to use as the Multiple, but a figure above 1 is typically used to give the investor an upside in return for taking a risk on the company.
The Conversion Amount, by contrast, is slightly more complicated to calculate. It depends on the CARE investment amount, the Discount Rate, and the amount payable on the company’s ordinary shares for the Liquidity Event (e.g. the price payable by the purchaser for the shares).
Imagine a CARE investor had invested $500,000 with a 30% discount (70% Discount Rate) and a Multiple of 1.5. If a third party purchaser agreed to pay $1.00 for each of the company’s shares, the investor would be entitled to a Conversion Amount of $714,285 ($500,000 ÷ (70% × $1.00)) or a Cash-Out Amount of $750,000 ($500,000 × 1.5). In this scenario, the investor would be entitled to their Cash-Out Amount as this is higher than their Conversion Amount.
Type of proceeds
The focus so far has been on cash only. However, the proceeds may include other types of asset and, notably, may not even include cash. The CARE tries to ensure the investor has the same opportunities as the company’s shareholders when it comes to the types of assets. Where, in a Liquidity Event, the company’s shareholders are given a choice about the type of assets they will receive, the CARE investor will be given that same choice.
If the third party purchaser mentioned above was a listed company, it might offer its own shares as payment for the acquisition as an alternative to, or instead of, cash. There may be benefits to accepting the listed company’s shares (e.g. if their value represents a premium to the cash option) and, if there is a choice, the CARE investor will be given that same choice.
If the listed company only offered its shares as payment and not cash, there is no choice to be made – the shares would be the form of payment. The exception to this is where the Liquidity Event is triggered by the company selling a cryptocurrency or digital tokens (i.e. an ‘Initial Coin Offering‘). In that case, even if cash is not an option, the CARE investor has a right under the CARE to choose cash. This strikes a balance between a modern contract that envisages Initial Coin Offerings, but does not force investors to receive a potentially illiquid and highly volatile cryptocurrency as payment.
You may have noticed that, when it comes to the amount the CARE investor is paid on a Liquidity Event, reference has been to what the investor is “entitled to” rather than what they will actually “receive“. This is intentional. The investor may be entitled to receive a certain amount, but there may be insufficient proceeds available for them to actually receive that amount. Investors should familiarise themselves with the Liquidation Priority waterfall, as this dictates who gets paid first in a Liquidity Event.