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Demystifying Liquidation Preference (Part 1)

June 7, 2024
5 mins

Introduction  

Central to VC investments is the concept of liquidation preference – a crucial element which shapes investment dynamics.  

Understanding liquidation preference is important for both venture capitalists (VCs) and founders due to its significant role on the distribution of exit returns. It may also influence the value of securities as it can alter the risk of the holding those securities. A security with a higher liquidation preference will limit its risk in relation to the returns.  

This article explores the nuances of liquidation preference in VC transactions, examining its mechanics, implications, and negotiation strategies. By unravelling this essential aspect, we equip stakeholders with the insights needed to navigate the complexities of India’s vibrant start-up ecosystem.

Liquidity Event

A liquidity event is a pivotal juncture in the life of a company where shareholders’ interests / ownership in the company converts into cash or other assets. This could occur through various means:

  • Mergers / Acquisition

A merger involves the amalgamation of two companies to form a new entity, while an acquisition entails one company purchasing all or a substantial stake in another. In both cases, investors in the acquired company have the opportunity to sell their shares and secure liquidity.

  • Third Party Sale / Strategic Sale

In a third-party or strategic sale scenario, the company may seek to sell its shares to an interested investor, whether strategic or otherwise. Existing investors in the company will then have the choice to sell their shares to this investor if the offered price is acceptable.

  • Sale of Assets

A company may opt to sell all or a significant portion of its assets, including intellectual property, machinery, etc., to generate liquidity. A sale of the assets may be undertaken for a number of commercial and regulatory reasons, such as:

  • The purchaser’s desire to avoid inheriting any regulatory or tax issues associated with the selling company;
  • The founder of the selling company may wish to retain the company for ongoing operations unrelated to the sold assets;
  • A slump sale of assets might offer tax efficiency advantages;
  • The procedures and documentation involved in purchasing assets may prove to be more time-efficient compared to acquiring the entire company.

Understanding Liquidation Preference

Liquidation preference, simply put, is the distribution priority and the amount to be paid to the shareholders of a company when there is a liquidity event.

Liquidation preference is commonly employed to safeguard against potential losses in scenarios where the returns from a liquidity event fall short of the agreed-upon amount. This prioritisation in distribution is pivotal, ensuring that investors or shareholders holding preferred securities receive payment before common shareholders in instances where the available funds for payout are insufficient to meet the agreed returns.  

The preference amount is the predetermined sum that preference shareholders are entitled to receive before equity shareholders. This amount usually includes the original investment made by the investors, along with any accrued dividends, if applicable. There are instance where this may be one and half or two times the original investment plus accrued dividends, depending on the funding terms and the investor’s requirements.

In the first quarter of 2023, Carta, a leading provider of cap table management software, reported that almost 9% of the 899 deals it recorded closed with a liquidation preference exceeding 1x. This marks a significant increase compared to the less than 2% reported just a year prior, as per Carta’s data.1

Liquidation Preference under Law  

While the Companies Act, 2013 does not call out liquidation preference, but does provide for liquidation protection. Section 43 of the Companies Act, 2013 gives holders of preference shares a preferential entitlement for repayment in the event of the company's winding up or repayment of capital. This entitlement extends to the amount of share capital paid-up or considered to have been paid-up, irrespective of whether there exists a preferential right to the payment of any fixed premium or premium on any fixed scale, as specified in the memorandum or articles of the company.  

A private company is permitted to specifically exclude this section, and provide for a different liquidation preference in its articles as agreed between the company and its shareholders / investors.

Under Section 53 of the Insolvency and Bankruptcy Code 2016 (IBC), the distribution of liquidation proceeds follows a waterfall mechanism. This mechanism prioritizes the settlement of debts, first with debenture holders, followed by preference shareholders, and finally equity shareholders.

Types of Liquidation Preferences: Participating and Non-Participating  

Another layer to liquidation preference is whether an investor participates in the final distribution of amounts or abstains from participating in such distribution.

Participating Liquidation Preference:

In a participating liquidation preference, investors will be entitled to not only receive their preference amount before the equity shareholders, but are entitled to also participate in the distribution of remaining proceeds with the equity shareholders, typically on a pro-rata basis.

This means that participating investors not only get their investment back but also a share of the remaining proceeds, potentially leading to higher overall returns.

Non-participating Liquidation Preference:  

A non-participating liquidation preference grants investors the right to receive their preference amount before equity shareholders. However, once investors receive their preference amount, they do not further participate in the distribution of proceeds with the equity shareholders.  

In essence, non-participating investors must choose between receiving their preference amount or converting their shares to equity shares and participating in the distribution like other shareholders of the company.

This structure provides downside protection for investors while also allowing equity shareholders (which include founders and employees) to benefit fully from any remaining proceeds beyond the preference amount.

Quick Comparison between Participating and Non-Participating Liquidation Preference

Current Trends on Liquidation Preference

Over the years, there is a notable trend toward fewer deals including participating liquidation preference terms, indicating a shift in negotiating power or a change in the risk profile investors are willing to accept.  

Trends for Q4 2022, showcases a decline in the use of participating preferred terms across early, later, and venture growth stages. This decline indicates a changing landscape where investors are less inclined to demand such terms, possibly due to evolving risk perceptions or a shift in negotiating dynamics. Particularly in early-stage deals, the graph illustrates high volatility initially, followed by a steady decrease to 11.8% by Q4 2022. This suggests a maturation of early-stage investing, where initial high demands for protective terms wane as companies prove their potential.

A graph of different colored linesDescription automatically generated
Source: Pitchbook

In contrast, a continuation of this trend into Q4 2023, projecting even fewer VC deals with participating preferred terms. This anticipated transformation signifies increased confidence in start-up growth and stability, diminishing the perceived necessity for investor-favouring terms. Notably, while early-stage investments are expected to see a steep decline to 5.8%, reflecting a robust start-up environment, later-stage and venture growth stage investments show more moderate decreases to 11.8% and 19.4%, respectively. These variations suggest a nuanced understanding of risk and reward among investors, adjusting expectations in response to market conditions and start-up performance.

A line graph with different colored linesDescription automatically generated
Source: Pitchbook

These trends highlight a potentially transformative period in VC investing, where market dynamics are increasingly favouring entrepreneurial ventures over conservative investment strategies, aligning investor interests more closely with long-term company success and ecosystem health.

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