Liquidation Preference - Part II

In the introductory part of this Article, we dealt with the manner in which liquidation preference rights were enforced. The second part to our Article focuses on the different categories of Liquidation Preference Rights.

Liquidation preference rights are of varying kinds, e.g., a non-participating liquidation preference right, a participating liquidation preference right, capped participation or chosen participation. Being a contractually agreed right, the contracting parties have a significant degree of flexibility to negotiate the nature and extent of the liquidation preference rights, which are then embodied within the legal agreements pertaining to the investment.

Non-participating

In a non-participating liquidation preference right entitlement, the investor has the right to receive either the equivalent of its investment (i.e. a 1x multiple) or, in certain instances, a higher multiple of the investment amount. The higher multiple may be 1.25x, 1.5x, 2x, 3x, etc. of the investment amount. The multiple decides the quantum an investor must be paid back before the remaining shareholders start receiving any remainder of the liquidation proceeds. This multiple is typically negotiated between the investee company and the investor prior to the investment being made.

Example: An investor with a 1x liquidation preference, who has invested ₹10,00,000, would (from the proceeds of a Liquidation Event) be paid back ₹10,00,000, prior to any distribution being made to other shareholders. For instance, if the Liquidation Event resulted in proceeds of ₹15,00,000, the investor would be guaranteed at least ₹10,00,000 out of this amount, regardless of the investor’s equity ownership at the time. However, if such proceeds are lesser than the amount invested by the investor, e.g. ₹9,00,000, the investor would be guaranteed the entire proceeds, since this amount of ₹9,00,000 falls under the assured 1X liquidation preference. Similarly, if such investor has the right to a 2x multiple, the investor would be paid back ₹20,00,000 from the proceeds of the Liquidation Event, before common shareholders are paid anything.

Participating

On the other hand, when an investor has negotiated for a participating liquidation preference right, the investor, after receiving the contractually agreed multiple of its investment, is further entitled to participate alongside other shareholders in the distribution of surplus proceeds from such Liquidation Event, proportionate to their inter-se shareholding in the company.

For instance, consider an investor who has invested ₹1,00,000 with a 1x participating liquidation preference in exchange for 20% ownership. If the total proceeds of a Liquidation Event is ₹2,00,000, then the investor would be guaranteed a sum of ₹1,00,000 (being the 1x liquidation preference amount), followed by a right to receive an additional 20% of the remaining proceeds. 20% of the remaining ₹1,00,000 would equate to an additional ₹20,000. Therefore, the total liquidation preference amount would be ₹1,20,000.

Capped Participation

A capped participation liquidation preference or a “restricted double dip” is where the investor receives his multiple, usually 1x of the investment amount, and furthermore, has a right to a share of the remaining proceeds in proportion to their ownership until it reaches a specified threshold amount. Such caps on the amount distributed are intended to protect the company and its other shareholders, while incentivising the investor at the same time.

For instance, an investor investing ₹1,00,000 for 20% stake in a company, in which there is a Liquidation Event with proceeds of ₹16,00,000. If the investor has a 1x participating liquidation preference, with a 3X cap on total returns, the investor will receive ₹3,00,000 as its total liquidation preference amount (i.e. ₹1,00,000 as 1X + ₹2,00,000 as capped participation).

Chosen Participation

The final approach to liquidation preference entitlement involves granting the investor the flexibility to choose their liquidation preference when there is an occurrence of a Liquidation Event.

The investor is allowed to select the option that yields higher proceeds. The available choices include the non-participating liquidation preference/ multiple or partaking in the proceeds distribution on a pro rata basis with other shareholders (based upon the inter-se shareholding of the investor and other shareholders). Usually, the investment agreement will provide that the investor shall receive the higher of the fixed return multiple, or pro-rated amount of the liquidation proceeds.

For instance, in the case of an investor who has invested ₹1,00,000 into a company with a 1x non-participating liquidation preference in exchange for 20% ownership (total valuation of the company would be ₹5,00,000), the investor would have two payout options when the Liquidation Event results in proceeds of ₹10,00,000, i.e. where the valuation of the company has doubled. The investor may exercise its 1x liquidation preference to receive a guaranteed ₹1,00,000 back, or participate with other shareholders on a pro rata basis for ₹2,00,000 (20% of ₹10,00,000). In such a situation, the investor would opt for the latter option. However, if the company saw a reduction in its valuation, and the proceeds of the Liquidation Event are thus lesser, the investor would benefit from opting for the former and recovering 1x of his original investment amount.

Seniority-based

Aside from the aforementioned approaches, there may also be situations where more recent/ later-stage investors will negotiate for a liquidation preference that places them as senior to early-stage investors on the happening of a Liquidation Event. This is often given as an incentive to pull in late-stage investors who would otherwise be reluctant to invest in a company whose value will unlikely to see more growth or shares are unlikely to increase in value.

In such an approach, the liquidation payout waterfall will be structured such that the most recent investors receive the first payouts, and the earlier investors receive a later payout (but still ahead of other shareholders in the company). For example, Series C investors will receive the proceeds before Series B investors, who will in turn receive it before Series A investors. This is of course a negotiated position and will require the consent and agreement of all the earlier investors in order to be contractually formalised.

In summary, the provision of a liquidation preference right serves as motivation for investors who are willing to bear the inherent risks associated with early-stage companies.

However, it is crucial to bestow this right judiciously upon investors to maintain an ample pool of capital, allowing equity shareholders such as founders and promoters to enjoy their rights as well. A wide range of approaches are available to align the priorities of founders with investors and enable the investors to receive their liquidation preference during a Liquidation Event.

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