Liquidation Preference 101

This blog post explains the right of Liquidation Preference, its usage, types, and the monetary consequences for a company’s shareholders during a liquidation event, with and without its inclusion in term sheets and shareholder agreements

Investments in early-stage companies are mired with risks and uncertainty. With a high probability of failure, investors in such ventures tend to incorporate several tools to help mitigate the risks involved, if not eliminate them altogether, and protect their capital. One such tool is the Liquidation Preference right (the “LP right”). Colloquially referred to as ‘liq pref’, it is a right conferred upon investors which entitles them to receive a specified portion of the net assets of a company or proceeds received during a liquidation event. The statutory backing for a LP right is found in sub-rules 2(b) and 2(c) of Rule 9 of the Companies (Share Capital and Debentures) Rules, 2014.

When is a Liquidation Preference Right Exercised?

A liquidation event does not include just the literal meaning, i.e., winding up of a company wherein its assets are sold and the proceeds distributed among claimants, but includes a range of events as specified, such as a merger or acquisition, change in control, divestment of material assets, resignation of key executives, etc.

A qualifying event (specified liquidation event) triggers the LP right which enables the holder of such a right to receive either the remaining portion of a company’s assets after creditors have been paid in full, or from the proceeds earned during a liquidation event other than a winding up of operations, which will be collectively referred to as ‘distributable proceeds’. The net distributable proceeds are a pool of monetary resources that a company’s shareholders have a right over. An LP right does not render the holder to supersede the hierarchy of claimants to a company’s distributable proceeds. For instance, a preference shareholder with LP rights cannot claim preferential treatment in distribution of proceeds over the creditors (be it financial or operational) of a company.

However, in case of a private company, an equity shareholder with LP rights may be able to supersede preference shareholders in staking a claim to a company’s distributable proceeds, if such a company’s Memorandum of Association or Articles of Association explicitly provides for the non-applicability of Section 43 of the Companies Act, 2013, which provides for the preferential right of preference shareholders to receive their invested capital during winding up or other events that generate distributable proceeds (As per the Notification issued by the Ministry of Corporate Affairs dated 5th June 2015)

The Workings of a Liquidation Preference Right

LP rights entitle the holders of such rights to receive from the portion of distributable proceeds, the value of their invested capital in terms of a multiple (Multiple on Invested Capital or MOIC) or in terms of percentage returns (Internal Rate of Return or IRR). There are two types of LP rights which will be explained below, for which a common example will serve as a reference point. Let us assume an investment of 3 crore rupees by an investor holding preference shares, who is also granted an LP right. One of the specified liquidation events triggers the investor’s LP right and results in distributable proceeds of 10 crore rupees that are to be distributed among shareholders. The investor with the LP right has a stake of 40% in the company’s share capital, with the remainder being held by equity shareholders.

The two types of LP rights include:

1.) Participating Liquidation Preference — Also called ‘Double Dip’, it entitles holders to receive their invested capital on the basis of an MOIC or IRR, as well as stake a pro rata (on a proportionate basis) claim on the remaining proceeds.

Building on the example above, and assuming the investor has a 2x participating liquidation preference right, the investor firstly, gets 6 crore rupees (3 crore rupees of capital invested multiplied by the MOIC of 2). The double dip enables the investor to dip their metaphorical beak in the pool (of the remaining proceeds) once again on a pro rata basis. Therefore, the investor receives 1.6 crore rupees (40% of the remainder, viz. 4 crore rupees), making his total returns 7.6 crore rupees on an investment of 3 crore rupees.

With participating liquidation preference, equity shareholders are on the losing end because the pool from which they receive returns shrinks as LP right holders stake their claims from the pool twice. Therefore, a tool called ‘Participation Cap’ buffers to a certain extent the reduction in equity shareholders’ returns caused by participating LP rights. Continuing with the same example, let us now assume that the investor has a 2x participating LP with a 2.33x participation cap. In this case, despite the investor being able to double dip, their total returns cannot exceed 7 crore rupees (3 crore rupees invested multiplied by 2.33). Therefore, with a 2x participating LP, the investor receives 6 crore rupees, and the second dip cannot be for a value of more than 1 crore rupees (as the total returns that can be earned are capped at 7 crore rupees), resulting in a pro rata share on the remaining proceeds of only 1 crore rupees as against the claim of 1.6 crore rupees without a participation cap.

2.) Non-participating Liquidation Preference — The non-participating LP right entitles holders to receive a specified portion of a company’s distributable proceeds based on a multiple (MOIC) or a percentage (IRR). The absence of double dip differentiates a non-participating LP right from a participating LP right.

Using the same example, the investor with a 2x non-participating LP right, receives 6 crore rupees from the pool of distributable proceeds of the company. This leaves equity shareholders with 4 crore rupees to be distributed on a pro rata basis.

Shareholder Payout Scenarios with and without Liquidation Preference

Let us now consider the various payout scenarios for a company’s shareholders during a specified liquidation event. The same example used above will be relied on.

As is seen in the various payout scenarios through the table above, an LP right drastically increases the holder’s return from 4 crore rupees to a maximum of 7.6 crore rupees with a participating LP right having no participation cap, all the while reducing equity shareholders’ claim from 6 crore rupees to 2.4 crore rupees.

Conclusion

A liquidation preference right incentivizes investors for taking on an early-stage company’s inevitable risk. However, such a right should be conferred moderately on investors so as to ensure availability of a sufficient pool of capital from which equity shareholders, typically founders and other executives, can stake a claim on. With the ability of a startup generating distributable proceeds being very low, a company’s pool of proceeds, if any, should be equitably distributed while ensuring that the reward mechanism is not unfairly skewed towards either of the sides through the usage of tools such as Liquidation Preference rights.