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Liquidation Preference in Venture Capital Deals

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Treelife

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Published on

September 7,
2023

Last updated on

August 20, 2024
21:41

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Blog Content Overview

1 What is Liquidation Preference?
2 How Liquidation Preference Helps an Investor?
3 Types and Mechanics of Liquidation Preference

What is Liquidation Preference?

A Liquidation Preference provision sets out the level of priority that an investors’ shares receive for the purpose of recovering their initial investment (or a multiple thereof) upon trigger of a liquidation event. A liquidation event typically includes winding up, sale of substantial assets of a company, change of control, merger, acquisition, reorganization and other corporate transactions, among others.

How Liquidation Preference Helps an Investor?

1	Recovery of Initial	A liquidation preference allows the investors to recover at least their initial investment in a company.
2	Multiple on the Initial Investment	A liquidation preference provision also allows the investors to earn a multiple on their initial investment, i.e., instead of 1x, investors may seek 2x or more, if so agreed.
3	Distribution in order of seniority	A liquidation preference clause allows the distribution of the proceeds to be in an order of priority on the basis of the series of securities held by the investors.

Types and Mechanics of Liquidation Preference

Types of Liquidation Preference

Type of LP	Particulars
Non-participating Liquidation Preference
1x	Allows the investors to recover only their initial investment in the company.
1x or pro-rata, whichever is higher* (single dip)	Allows the investors to recover their initial investment or entitles them to the proceeds from the liquidation event, basis their pro-rata shareholding in the company (on an as-if converted basis), whichever is higher.
Participating Liquidation Preference
1x (double-dip)	Allows the investor to recover their initial investment (or a multiple thereof) in addition to a right to participate in the remaining proceeds basis their pro-rata shareholding in the company.

*Note:The multiple on the liquidation preference may be more than 1x and the amount of distribution of the liquidation preference shall be determined basis such a multiple.

Let us understand the mechanism of different types of liquidation preference through the below illustration:

Investment Amount	INR 10cr
Percentage shareholding in the Company	10%

Scenario 1: Non-participating liquidation preference

1x or pro rata, whichever is higher

Total Liquidation proceeds*	Investors’ liquidation entitlement (2x)	Investors’ liquidation entitlement (pro-rata)	Actual entitlement
INR 20cr	INR 10cr	INR 2cr	INR 10cr.
INR 200cr	INR 10cr	INR 20cr	INR 20cr.

*Note: The total liquidation proceeds are the total proceeds from a liquidation event which are subject to distribution between the shareholders.

2x or pro rata, whichever is higher

Total Liquidation proceeds*	Investors’ liquidation entitlement (2x)	Investors’ liquidation entitlement (pro-rata)	Actual entitlement
INR 20cr	INR 20cr	INR 2cr	INR 20cr.
INR 400cr	INR 20cr	INR 40cr	INR 40cr.

This form of liquidation preference is most desirable as, while it allows the investors to recover their initial investment, it also enables them to take advantage of the upside in case the larger proceeds are accumulated from a liquidation event.

It is however, not recommend signing up for a multiple on the investment amount.

Scenario 2: 1x (participating liquidation preference)

Total Liquidation proceeds*	Investors’ liquidation entitlement (1x)	Investors’ liquidation entitlement (pro-rata)	Actual Entitlement
INR 20cr	INR 10cr	INR 2cr	INR 12cr
INR 500cr	INR 10cr	INR 50cr	INR 60cr.

While this may seem like a desirable form of liquidation preference, in the event the structure of a liquidation is not pari passu, i.e., in case the liquidation clause provides for a seniority, this may lead to disadvantage to the holders of equity shares (in most cases, the founders).

Conclusion

In conclusion, while liquidation preference is a crucial right for the investors, it is important for the founders to be mindful about the construct of this provision.

Early stage founders are recommended to consider the 1x non-participating liquidation preference, preferably provided in Scenario 1. Excessive or stringent liquidation preferences can deter future investment rounds and put the founders at risk of reduced share in the liquidation proceeds.