First In Line: Decoding Liquidation Preferences For Investors And Founders

In the realm of Private Equity and Venture Capital transactions, a well-structured exit is as critical as the initial investment itself. The liquidation preference clause serves as a key contractual mechanism to ensure that investors are afforded priority when a company undergoes a liquidation event. Far from being a routine provision, this clause effectively places investors at the front of the distribution queue, ensuring recovery of capital before any residual proceeds are allocated to common shareholders.

At its core, liquidation preference grants the investor the right to recover their original investment amount, often accompanied by a pre-agreed premium or return. In certain structures, notably under a participating liquidation preference, the investor is further entitled to participate in the remaining proceeds alongside other shareholders, thereby enabling a dual recovery mechanism. This not only enhances downside protection but also preserves a share in the upside, should the company's exit valuation permit.

Liquidation Preference in the Real World: What's The Catch?

The liquidation preference clause operates as a contractual safeguard that entitles investors typically holders of preference shares to receive a priority payout in the event of a liquidation. In effect, it ensures that once statutory liabilities such as payments to creditors and employees are discharged, investors are next in line to recover their investment, in accordance with the agreed distribution waterfall. However, it is important to note that liquidation preference clauses do not override the statutory framework governing liquidation in India i.e. Insolvency and Bankruptcy Code, 2016 (“IBC”). Section 53 of IBC sets out the waterfall mechanism i.e. the order of priority of distribution of assets for a company undergoing liquidation. This section further stipulated that any contractual arrangement between recipients with equal ranking which disrupts the order of priority is to be disregarded by the liquidator. Nevertheless, a question may be raised as to whether a liquidation preference between two shareholders holding the same class of shares may be enforced. IBC also suggests that at each stage of the distribution of proceeds in respect of a class of recipients that rank equally, each of the debts will either be paid in full, or will be paid in equal proportion within the same class of recipients, if the proceeds are insufficient to meet the debts in full.

Illustration: Consider a scenario where two investors hold the same class of shares, each asserting rights under separate liquidation preference arrangements. One might assume that the more favourable contractual language or negotiating leverage would determine the outcome. However, under IBC such assumptions do not hold. The IBC provides that within a class of similarly ranked stakeholders, distributions must be made on a pari passu basis i.e. equally and without preference unless expressly provided otherwise by law. In essence, no shareholder within the same class can be prioritised over another, regardless of any internal contractual understanding.

Previously, under the Companies Act, 1956 and 2013, used to enable companies to divide their assets amongst shareholders according to their rights and interests in the company, subject to the content regarding the same in the Articles of Association of the company, provisions relating to preferential payments and satisfaction of liabilities in full. But with the introduction of IBC, Section 320 of the Companies Act, 2013 along with the law related to voluntary liquidation has been repealed. The present law on voluntary liquidation is found in ChapterV of the IBC. By virtue of Section 59(6) of the IBC, payments must be made in the same order of priority as is applicable to compulsory liquidation.

But Don't Worry, There's a Catch

While the liquidation preference clause may have its limitations, investors can still negotiate a way to get ahead of the line. The solution? Put options, drag-along, and tag-along rights, basically, these special rights safeguard the investor's money without waiting for a company to hit rock bottom. Now, here's where it gets interesting: the Companies Act, 2013 allows companies to create different classes of shares provided the articles of the Company authorize them to do so. As a result, investors may also consider negotiating for preference shares, or a class of shares separate from those of promoters or setting up an exit mechanism prior to actual liquidation. However, an equity shareholder cannot be better placed than a preference shareholder or any other group of stakeholders that fall before equity shareholders in the waterfall mechanism provided in Section 53 of IBC.

Types of Liquidation Preferences

Liquidation preferences can be bifurcated in the below stated heads. The two major ones are participating and non-participating preferences, but there are also variations like capped participating preferences and multiple preferences. Let's understand these terms:

1. Non-Participating Liquidation Preference: Investors either get their full investment back or convert their preferred shares into common stock to join the payout party. The better deal? They get whichever option gives them more money.

Example: An investor puts in ₹40 crore with a 1x liquidation preference. If the company exits for ₹100 crore, they'll first get their ₹40 crore only. However, if they're entitled to convert into common stock and their share of the company would be worth more, the investors can choose to opt to do so.

2. Participating Liquidation Preference: The investor gets their investment back first and then also takes a cut in the remaining proceeds alongside the common shareholders. This is often referred to as "double-dipping."

Example: An Investor puts in ₹35 crore investment in a company. If the company exits for ₹100 crore, the investor takes their ₹35 crore plus a share of the remaining ₹65 crore. If the investor owns 25% of the company, they will also receive ₹16.25 crore, totaling his receivables to be ₹51.25 crore.

3. Capped Participating Liquidation Preference: Investors get their investment back first, but there's a cap on how much they can “double-dip” into the remaining proceeds. Once they hit that cap, they cannot receive anything else.

Example: An Investor puts in ₹35 crore investment in a company. His receivables are capped at ₹60 crore total. If the company exits for ₹200 crore, he'll take ₹60 crore (₹35 crore from liquidation preference and ₹25 crore from participation), but nothing more, even though there's still plenty left for the common shareholders.

4. Multiple Preferences (e.g., 2x, 3x): This is where things get really interesting. Investors may demand to get back 2x or even 3x of their investment before anyone else gets a penny. This is more common in high-risk or later-stage transactions.

Example: A 2x liquidation preference on a ₹10 crore investment means the investor will get back ₹20 crore before anyone else gets paid.

Why Liquidation Preference Matters to the Investors

Liquidation preferences are the safety net for investors in risky businesses. Startups can have high failure rates, and investors need a way to protect themselves if things go south. Liquidation preferences ensure that in a bad exit scenario (say, a company is sold for far less than its valuation), investors at least get their money back before common shareholders see a rupee.

But the impact of this can be pretty stark for founders and employees. While the investors are guaranteed a payout, the common shareholders could get very little or, in some cases, nothing. So, it's crucial for founders to be aware of how these preferences affect their potential return when the company is sold or liquidated.

The Devil is in the Details

The devil, as they say, is in the details. Liquidation preferences are negotiable. This means that founders have room to negotiate the terms of the preference, especially in the early rounds of funding. Founders can try to limit the preferences to non-participating or push back on higher multiples. The key is balance while investors want protection, they also want the company to grow enough so that they can eventually convert to common stock and share in the upside.

But it's not all roses. Investors and founders have to face the prospect of failure head-on and allocate risk accordingly. This requires some tough conversations and clear agreements on what happens if the company is sold for less than expected or even goes bankrupt.

The Changing Trends

Interestingly, recent trends suggest that fewer deals now include participating liquidation preferences, particularly in the early stages. As startups prove their potential and investor confidence grows, investors are becoming more flexible, and the need for "double-dipping" is declining. This shift indicates a maturation of the startup ecosystem, where early investors are becoming less reliant on liquidation preferences as a protective mechanism.

Final Thoughts: Navigating the Preference Maze

Liquidation preferences play a pivotal role in protecting investors, but they can complicate the payout process for founders and employees. As a founder, understanding these preferences and negotiating terms that are fair to both parties is crucial. For investors, it's about finding the right balance between downside protection and potential growth, ensuring that the preferences reflect the true risk profile of the investment.

In this dynamic business world, where exits can range from a multimillion-dollar sale to bankruptcy, liquidation preferences are the ultimate safety net. But like any good safety net, it's best to ensure it's balanced i.e. protecting the investor without leaving the founders hanging.

Authors: Adv. Ravi Prakash (Associate Partner), Adv. Menali Jain (Associate) At Corporate Professionals Advisors & Advocates. Views are personal.