Corporate Law Newsletter – All About Liquidation Preference: July 2023

Liquidation preference right is a key constituent in private equity and venture capital transactions. A liquidation preference clause provides preference to the investors at the time of distribution of proceeds in a liquidation event or a deemed liquidation event, thereby, providing downside protection to the investors in such events. From an investment transactions standpoint, liquidation events typically include actual liquidation, winding-up or dissolution of the company or sale of material assets or any corporate reorganization, transfer of securities or any other transaction that results in a change of control.

Types of Liquidation Preference

1. Participating Liquidation Preference: Participating liquidation preference means that in addition to the preferential payment that the investor receives out of the distribution of liquidation event proceeds, the investor is also entitled to participate in the surplus liquidation proceeds remaining after payment of the preferential amount to the investor in proportion to the shareholding of the investor on an as-converted basis. This is also commonly known as a double dip.
2. Non-Participating Liquidation Preference: Non-participating liquidation preference means that investors will not be entitled to participate in the distribution of surplus liquidation proceeds which are available for distribution among the other shareholders of the company.

Standard Liquidation Preference Construct

A standard non-participating liquidation preference clause is as follows:

“Upon the occurrence of a liquidation event, the investor shall be entitled to receive from the total proceeds of such liquidation event remaining after discharging all liabilities of the company in accordance with applicable law, in preference to the other shareholders, the higher of: 

• 1x of the amounts invested by the investor; and
• Pro-rata share of the investor in the liquidation proceeds in proportion to the shareholding of the investor in the company on an as-converted basis.”

Generally, the downside protection in liquidation preference clauses is set in terms of an investment multiple which is typically pegged between 1x to 2x of the investment amount. The commonly used liquidation preference mechanism is a non-participating liquidation preference with a 1x multiple, which ensures that the investors take away at least their investment amount. Further, in the event the liquidation proceeds are insufficient for the payment of the liquidation preference amount of the investor, then the investor is entitled to take away the entire liquidation proceeds. A clause to that effect is incorporated in the liquidation preference construct.

Illustrations

“X” has invested an amount of INR 1,00,00,000 (Indian Rupees One Crore) in “ABC Private Limited” and holds 10% (Ten Percent) of the share capital of ABC Private Limited on an as-converted basis. 

In each scenario above, the liquidation proceeds remaining after payment of the actual payment amount (set out in column D) will be distributed among the other shareholders on a pro-rata basis in proportion to their shareholding on an as-converted basis.

Liquidation Preference for Multiple Investors

In cases where a company has multiple investors, liquidation preference rights may be given to them either on a pari-passu basis such that all the investors have seniority in payment of liquidation proceeds basis their proportionate shareholding or through a waterfall mechanism whereby holders of a particular class of securities (typically, securities issued to investors in the latest funding round) get preferential right above all other class of securities. For example, in a company that has had a Seed Funding Round (wherein Seed Series Securities were issued) and a Series A Round (wherein Series A Securities were issued), either Seed Round Investors and Series A Investors, both, may have pari-passu liquidation preference or the holders of Series A Securities may have seniority over holders of Seed Series Securities. 

Enforceability of Liquidation Preference Rights

Section 43(1) of the Companies Act, 2013 provides that the share capital of a company limited by shares can either be equity share capital or preference share capital. Further, preference shares carry a preferential right with respect to payment of dividends and repayment in case of liquidation, winding-up or repayment of capital of the company. 

Section 47 of the Companies Act, 2013 provides for a distinction between equity shares and preference shares in terms of the voting rights attached to such shares. While holders of equity shares are entitled to vote on every resolution placed before the company, holders of preference shares can only vote on matters which directly affect the rights attached to the preference shares or with respect to winding-up or repayment of capital of the company.

However, the Ministry of Corporate Affairs, vide notification dated June 5, 2015, notified that private companies may be exempt from the applicability of Section 43 and Section 47 where the memorandum of association and articles of association of the company provide for such exemption. Therefore, pursuant to the said notification, private companies can issue preference shares with voting rights rather than issuing equity shares with differential voting rights and may provide preferential rights of payment to the holders thereof. Having said that, it must be noted that the enforceability of the liquidation preference mechanism has not been tested in Indian courts. Further, implementation of a liquidation preference right would have its own challenges on a case-to-case basis and may have to be looked into from an exchange control laws perspective and taxation standpoint.