#SHA101 Liquidation Preference — Tread with Caution, lest the Founder Value might Vaporise!

Hope you are doing well. Welcome back to Seeking QapitaL blog!

After a long-ish break, I am back with the next blog on the #SHA101 series. Let’s continue our discussion on key SHA/Termsheet clauses that as a founder you should be aware while negotiating with your potential investor.

So far we covered:

1. Definitive Agreements — SSA/SHA/SPA. Because mere shaking-on a deal is not ‘definitive’ enough!
2. Pre-Emptive Rights: Everyone wants to keep betting on the winning horse!
3. Transfer of Shares Rights — ROFO & ROFR
4. Transfer of Share Rights | Promoter Lock-In | You Shall Not Pass!
5. Transfer of Share Rights | Tag Along and Drag Along

In this blog, we discuss yet another extremely important clause/right that typically investors possess as part of the termsheet or SHA: Liquidation Preference.

Liquidation Preference

Liquidation Preference can have serious implications for founders in terms of the value they can generate from their hard-earned labour of love — their startup. Read on to understand this further.

In simple terms,

Liquidation Preference is the right that certain preferred shareholders (typically investors) possess which gives them a preference or a priority on how cash proceeds are paid out to the shareholders in the event of a liquidation.

A Liquidation event could mean both:

• An exit/acquisition event where a third party is acquiring the company or
• The company is dissolving/liquidating by selling all its assets.

Typically investors and shareholders with preferred class of shares are paid out before promoters. Let’s understand a few more nuances and terminologies associated with liquidation preference.

Waterfall, Priority & Participating Right

A typical liquidation preference clauses talks about a few aspects:

Priority Order or Liquidation Waterfall

A typical capital structure of the company has a combination of debt and equity.

• Debt is typically senior to equity.
• Within the class of equity shareholders there can be further hierarchy in terms of preferred share class which is senior to common shares.
• Further there can be a preference order (waterfall) within the preference classes themselves. For eg. Series C share class might rank senior to Series B and so-on. And hence a typical liquidiation waterfall might look like this:

Multiplier (1x or 1.5x or 2x)

Apart from the priority of the various share class holders, each share class can also have a multiplier property.

Multiplier determines the quantum of liquidation proceeds that the class holders should receive as priority liquidation proceeds as per the waterfall order.

By default this is 1x, which is also fair, as investors would want to recover their valuable capital in case the company were to go under. However, some investors could also demand a higher liquidation proceeds (beyond 1x), say 1.5x or say even 2x of the invested capital to assure themselves of a return before the promoters and junior shareholders make any money of the exit.

This could turn out to be quite penal for founders, as you can see from an illustration towards the end.

Participating Right

As if the liquidation multiplier itself was not enough, certain investors would also demand an additional participating right as part of liquidation preference. This ensures that once the investor recovers their liquidation proceeds as per the multiplier indicated, that investor further has the right to proportionally get paid incrementally to the proportion of their shareholding, hence ‘participate’ further in the allocation.

Mind the La(w)nguage

A typical LP clause would be drafted legally as follows. While this is a simple clause assuming one investor class, if there is further hierarchy within investor clauses, LP clauses tend to get very long consisting of multiple paragraphs.

In the event that the Board resolves to undertake any sale or transfer of Securities or sale, transfer or disposal of assets of the Company, or undertake any merger, demerger, restructuring or reorganisation that has a similar effect (“Liquidity Transaction”), the Investor shall be entitled to be repaid the greater of (i) The Investment Amount plus all declared but unpaid dividends or (ii) a pro rata amount of any assets or cash available to be distributed to the shareholders of Company.

This is a simple liquidation preference class assuming just one investor class, however if there are multiple classes, you will find many sub clauses for each class of shares to articulate the waterfall

Founders should watch out for:

Liquidation Preference as such is mostly a standard clause you find in most termsheets and SHAs and I don’t think founders can really negotiate not to have it. However, founders can ensure that they do not accept clauses that are unfriendly and penal to them and are also increasingly considered non-market-standard. Couple of them are listed below:

Multiplier over 1x

While most investors do demand a 1x liquidation mulitiplier, any factor higher than 1x should be avoided by the founders. This has the potential of wiping out any proceeds going to the founder.

Participating Right

Founders should also negotiate hard on giving away participating right to investors. As it is investors have a priority to recover their principal before other shareholders get any money out of the total proceeds. Given this existing advantage:

A participating right acts as a double whammy for the founders. Not only do they have to pay the investors in full (as per the multiplier), any left over proceeds is further allocated to the investor as per their shareholding.

Let’s take an example.

• Let’s assume Investor A invests INR 1CR in a startup for 20% stake. Promoters own 80%
• Now the startup gets liquidated with proceeds worth 2CR

In case of (1x LP and no participating right):

• Investor gets higher of 1x of INvested capital or proceeds as per shareholding i.e. higher of 1CR or 20% of 2CR (40L) ⇒ 1CR
• Promoters get the remaining amount: 1CR (although proportionally they would have claimed 1.6CR, 80% of 2CR)

In case of (1.5x LP and no participating right):

• Investor gets higher of 1.5x of Invested Capital or proceeds as per shareholding ⇒ 1.5CR
• Promoters get the remaining amount: INR 50 Lakhs only

Now if we add participating right to the above case (1.5x LP and with Participating right):

• Investor gets 1.5CR first as Liquidation Preference Proceeds. Further the 50 lakhs is proportionally distributed including the investor ⇒ 20% of 50L ⇒ 10 L. Hence Investor this time makes 1.6CR
• Promoters are left with INR 40 Lakh only ⇒ further squeezing the proceeds available to the promoters

Now imagine there was a 2x Liquidation Preference

• Perhaps, I don’t need to explain the implication for the founders. The entire proceeds would be claimed by the investor (2x of 1CR) and nothing is left for the founders.

The below illustration visually represents the above scenarios:

As you can see, as the LP clauses favour investor, Founder Proceeds from the Liquidation Event could even go to Zero!

Hence, as I mentioned in the title, if the founders are not careful of the clauses they are signing up for, Liquidation Preference has the ability to vaporise all of founder’s value in the company.

This reminds me of my bond structuring days at an Investment Bank where I used to package all kinds of good, bad and ugly loan assets into Investment Grade and Sub-Investment Grade bond tranches. Well, now that I think about it, as a Founder, perhaps I am at the borderline Sub-Investment Grade tranche.

When outcomes are great, everyone benefits and life’s good.

When outcomes are sub-optimal: Founders are the first ones to loose.

And do remember that in a startup the odds of a favourable outcome (exit or unicorn status) are severely against the founder based on past data. Hence, importance, of these clauses and such payout waterfalls is amplified.

So please watch-out for all implications before you sign on the dotted line :)

In the next edition, I’ll further visually elaborate the implications of LP Waterfall in a more complex captable. So stay tuned. :)

Meanwhile, Qapita helps founders run these liquidation waterfall models by click of a button. Here is a sample 👇. Reach out to us if you wish to run this for your company.

Connect with me: srikanth@qapitacorp.com; LinkedIn; Twitter

PS:

As a slight aside, do you remember this clip from the movie: The Big Short? Any parallels you can draw? :)