For the last few weeks I have been discussing exit strategies. Today, we will wrap up the topic by discussing company dissolution.
Generally, dissolution is not a strategy people plan to do, though there are exceptions. Funds, for instance, are intended to have a limited lifetime. At the end of that life, the fund is dissolved and any assets of the fund are distributed to the investors. Even if your company is not one that you create for a limited purpose and intend to dissolve, understanding company dissolution is important as it represents a “worst case scenario” for the firm.
When a corporation is dissolved, the first thing to occur is that all creditors are paid in full from the assets of the company (assuming the company does not need to be put through bankruptcy). The remaining assets of the company are then distributed to shareholders. Often, this involves liquidating the assets, but occasionally shareholders will accept in-kind distributions of assets.
If all the shareholders have common stock, then the distribution will be on a pro-rata basis determined by the percent of the company each shareholder owns. This distribution, however, can be dramatically affected by preferred shares. Some shareholders will have a preference guaranteeing them a particular amount upon dissolution. In that event, the preferred shareholders must have their preference paid out first. If the stock is participating preferred, then the preferred shares will be included in the distribution of any remaining assets after the preference is paid out. If they are not participating, then only the common shares will be used in the calculation of the asset distribution.
For example, suppose a company has three classes of shareholders. 80 shares of common stock are outstanding. 20 shares of participating preferred stock are outstanding containing an aggregate preference of $50 to be distributed to the shareholders. 10 shares of non-participating preferred stock are also outstanding, and these have an aggregate preference of $50 to be paid out as well. The company has $200 in assets at the time of dissolution.
First, the preferences would be paid out, $50 to the participating preferred shareholders and $50 to the non-participating preferred shareholders. This leaves $100 in assets in the company. This is then distributed among 80 common shares and 20 participating preferred shares on a pro rata basis, resulting in $1 per share to be distributed.
The main downside of company dissolution as an exit strategy is that the company no longer exists afterward. Such a strategy is, therefore, only a good choice if 1) necessary due to poor company performance or 2) if the company is created only for a limited purpose or project.
We are going to conclude the series on exit strategies here. Understand that there may be other strategies for you to pursue and that not every strategy will be available to your company. Knowing some of your options, however, will help you gauge how best to repay your investors. Next week we will discuss dividends as an alternative means of getting capital to your investors without having to exit the company.