A Founder’s Guide To Understanding Liquidation Preference

 What is Liquidation?

Liquidation is the process of bringing a business to an end and distributing its assets to its claimants. It is an event that usually occurs when a company is insolvent, meaning it cannot pay its obligations when they are due. As company operations end, the remaining assets are used to pay creditors and shareholders, based on the priority of their claims.

Understanding the concept of Liquidation Preference

Liquidation preferences are a key negotiating point that potential investors bring up during fundraising and the outcome of the negotiation can significantly impact their earnings for their investment upon a successful exit. To negotiate well, a founder needs to understand what a liquidation preference means, what the different types are and why investors request these terms. 

First, we need to understand what kinds of shareholders are eligible for a Liquidation Preference. Section 43 of the Companies Act, 2013 characterizes the share capital of a company limited by shares into – (i) equity share capital (either with voting rights or with differential rights to dividend, voting or otherwise) and (ii) preference share capital. Preferred shareholders enjoy preferential treatment in payment of dividend as well as repayment in the event of liquidation, winding up or repayment of capital of the company.

A Liquidation Preference is a proviso in a shareholders’ agreement that directs the compensation in the event of a corporate liquidation. Commonly, the company's preferred shareholders recover their investments first, prior to all other shareholders, in the event the Company undergoes liquidation. Liquidation preferences are frequently utilized in investment agreements to explain what the investors get paid in return for their investments and in which order on the occurrence of a liquidation event, such as in the sale of the company. Liquidation preference essentially dictates who gets how much when an organization is liquidated, sold, or goes bankrupt.

Liquidation preferences are expressed as a multiple of the initial investment. They are most commonly set at 1X, meaning that investors would need to be paid back the full amount of their investment before any other equity holders.

Why do Investors ask for Liquidation Preference?

Liquidation preferences serve as a form of protection for investors, especially in situations where a company fails to meet expectations and sells or liquidates at a lower valuation than expected. This is because the liquidation preference essentially guarantees a certain minimum payment due to investors regardless of the company’s valuation at exit, whether that is a sale or the company going out of business.

Types of Liquidation Preference

(i)                Non-participating Liquidation Preference

Under non-participating liquidation preference, the investor will be entitled to receive its predetermined returns, but shall not be entitled to receive any portion of the surplus proceeds to be distributed to the equity shareholders These are the most commonly used. If an investors’ preferred stock contains non-participating liquidations preferences, the investor can choose to either (1) receive the pre-determined liquidation preference amount or (2) share in the proceeds in proportion to the investor’s equity ownership after converting the preferred shares into common stock. In almost all scenarios, the investor chooses whichever option provides the larger return.

 (ii)              Participating Liquidation Preference.

Here, the investor is not only entitled to pre-determined returns but is also entitled to the distribution of the surplus proceeds based on his shareholding in the company on a fully diluted basis. This is also referred to as “Double-Dip”

A mathematical representation of the aforementioned concepts is stated below: 

FACTS: 

Startup- ABC Private Limited

Investor-XYZ Ventures, 

Investment amount: USD 5 million for 20 percent of equity in the Startup with predetermined liquidation preference of 1x of the Investment Amount. (this typically ranges from 1x to 1.5x depending on the deal size)

Liquidation Event Proceeds = USD 100 million

1. As per  Non-participating Liquidation Preference,  XYZ Ventures will have the option to take the greater of USD 5 million or 20 percent of USD 100 million.  Here, XYZ Ventures will opt for the later and take away USD 20 million;
2. As per the Participating Liquidation Preference, XYZ Ventures will have the right to take USD 5 million first and then partake 20% in the remaining USD 95 million as well. This totals the aggregate amount of return to XYZ Ventures to USD 24 million (USD 5 million + 20% of USD 95 million).

(iii)            Other important practises regarding Liquidation Preferences:

a.      Standard Seniority Liquidation Preference: This is a structure followed by most early-stage companies. Here, the liquidation preferences are honored in reverse order from the latest investment round to the earliest. Thus, the Series B investors would receive their liquidation preference amount before the Series A investors, who, in turn, would receive their liquidation preference amount before Series Seed investors, etc.

b.     Pari-Passu Seniority: This practise gives all preferred investors equal seniority status, meaning that all investors would share in at least some part of the proceeds. If the proceeds from a sale cannot cover every investors’ liquidation preference, the payouts are made in proportion to the amount of money invested (which does not necessarily correlate to ownership).

c.    Tiered Seniority: This can be thought of as a hybrid between standard and pari-passu seniority. With tiered seniority, investors from different funding rounds are grouped into distinct seniority levels that follow the standard seniority format. However, within each tier the payouts follow the pari-passu format.

What Founders need to understand:

To sum up, the two most important attributes of the Liquidation Preference terms are “preference” and “participation”. The preference controls the proceeds that are paid to the investor before they are required to share and the participation controls how any subsequent sharing happens.

The way a founder negotiates this clause from the first angel round itself is crucial in determining how the investors in future rounds will put forth their terms. It is imperative that the founder does not create a precedence that would lead to putting the common stock shareholders in a disadvantageous position in future funding rounds. Therefore, being well versed with these concepts and understanding its impact on their respective businesses is essential for every founder looking to pick up an investment from a seasoned investor.

Disclaimer:

This article has been prepared for general guidance and information as a guide to understanding the concept of liquidation preference from a founder’s perspective and does not constitute professional advice or a legal opinion and are the personal views of the author. The matters described herein are general in nature and have not been evaluated based on applicable laws. This article is based on information available in the public domain and has not been verified for its accuracy. You should not act upon the information contained in this note without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this note. Treelife Consulting and its employees accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Without prior permission of the author / Treelife Consulting, this note may not be quoted in whole or in part or otherwise referred to any person or in any documents.