Liquidation Preference - Part I

In the midst of ongoing shifts in the global economic terrain brought about by factors such as technological advancements, geopolitical uncertainties, and epidemics, investors worldwide are actively seeking more dependable approaches to mitigate risks and preserve the worth of their investments. A widely adopted measure in fundraising agreements that seeks to address this need is the liquidation preference right typically provided to financial investors by their portfolio companies.

The liquidation preference right, found in investment agreements like shareholder agreements, acts as a protective measure for financial investors who have backed their investee companies with capital. This right ensures that in instances such as an investee company facing a Liquidation Event, financial investors are entitled to receive their invested amount, along with a possible predetermined percentage of the proceeds which arise as a consequence of such a Liquidation Event, ahead of other stakeholders in the company.

The purpose of a liquidation preference is therefore to protect investors and ensure that they are not forced to exit from the investee company at a value lower than their initial investment amount, and to provide them with a preferential position (as compared to other shareholders) during a Liquidation Event.

The manner in which the liquidation preference right is implemented and realised differs based on the specific nature of the Liquidation Event in question. Some illustrations of this variance are considered in the ensuing sections of this article.

A common and frequent example of a Liquidation Event is the sale of shares of the investee company resulting in a change in control event, i.e. where there is a change in the majority shareholding of the investee company from one or a group of shareholder/s to another.

In this case, the purchaser of the shares of the investee company transfers cash consideration to the selling shareholders on a pro rata basis. The investment agreement will typically provide that the investor should realise the higher of (i) the investment amount invested by it into the company, plus any declared but unpaid dividends, and (ii) the pro rata share (based on the investor’s shareholding) of the liquidation proceeds. This implies that if the sale of shares is taking place at a company valuation which is lower than the investor’s original investment, the investor should be paid at least the investment amount. As a natural corollary, this would also imply that the per-share purchase consideration paid to the investor would need to be higher than the per-share consideration.

If, however, the sale of shares is taking place at a company valuation which is higher than the investor’s original investment, the situation becomes less complicated. In this case, the investor would receive the pro-rated portion (i.e. proportionate to the investor’s percentage holding within the shares being sold) of the entire purchase consideration.  

A merger of the investee company with another entity would also typically be considered a Liquidation Event. In such an event, the shareholders of the investee company (including the financial investor in question) would receive shares in the surviving “transferee entity.” The number of shares of the transferee entity that would be received by the investor would depend upon the respective valuations of the investee company, i.e. the “transferor entity” and the transferee company. The guiding principle should be that the value of the shares of the transferee entity that are received by the investor consequent to the merger should be equivalent in value to the liquidation preference amount that such investor would have received in accordance with the original investment agreement.

Winding up or liquidation of a company is the procedure of ceasing the activities of the company, selling the assets of the company and distributing the proceeds of such sale among its various stakeholders in an equitable and legally regulated manner.

The funds obtained from this realization of assets shall be distributed as per the waterfall mechanism enumerated under Section 53 Bankruptcy Code, 2013 (“IBC”). Any remainder of proceeds shall be distributed among preference shareholders, followed by equity shareholders. Thus, a liquidation preference right would not empower the right-holder to enjoy rights which militate against the prescribed hierarchy of claimants in a winding up proceeding under Section 53 of the IBC. For example, a preference shareholder possessing contractual Liquidation Preference rights would not, in the course of winding up or liquidation proceedings, be entitled to distribution of proceeds in a manner that is inconsistent with the statutorily prescribed mechanism.

It is also noteworthy that due to a 2015 Ministry of Corporate Affairs notification [Ministry of Corporate Affairs Notification G.S.R. 464(E)], the superiority of preference shareholders over equity shareholders for the distribution of winding up proceeds will not hold true in a private company if its charter documents explicitly state the inapplicability of Section 43 of the Companies Act, 2013 with respect to the preferential right of preference shareholders to receive their invested capital in events like winding up or other events leading to the generation of distributable proceeds.

Both asset sales or slump sales by an investee company are considered to be Liquidation Events, since the company is in both instances being divested of its core assets and/or business/business undertaking. An asset sale refers to the sale of key assets by a company. A slump sale or business transfer refers to the sale of all assets and liabilities of the company as a going concern, where a lump-sum value is attributed to the business being sold instead of values being assigned to individual assets.

Unlike in the case of a sale of shares of the investee company, the purchase consideration and proceeds for an asset sale or slump sale are received by the seller company directly (rather than by the shareholders of the seller company). Pursuant to such a sale, the proceeds of such sale received by the company are required to be distributed after considering and accounting for the liquidation preference rights of the financial investors of the company. Once the investor has received the contractually stipulated liquidation preference amount, the remaining proceeds (if any) may be distributed to the remaining shareholders, typically in proportion to their shareholding.

The manner in which such proceeds received by the investee company may be distributed to its shareholders needs to be carefully considered. There may be multiple avenues for achieving this objective, and each carries its advantages and disadvantages. For instance, these sale proceeds received by the company may be distributed by the company by way of dividends to the shareholders, including the financial investors. However, this would entail the company being profitable and having enough free reserves to declare and distribute dividends to its shareholders in accordance with the provisions of the Act [Section 123 of the Companies Act, 2013]. Alternatively, the company may also consider cumulative dividends, which typically accumulate starting from the shares' issuance date until the exit from the company. The investor may also be paid through other means such as fees for professional advisory services rendered by the investor to the company under suitable contractual arrangements executed between the company and the investor.

In the second and concluding part of this article, we will examine the various mechanisms through which a liquidation preference right is typically enforced and exercised.

About the authors: Arindam Basu is a Partner, Bilal Lateefi is a Principal Associate and Varun Rao is an Associate at Poovayya & Co.