I. INTRODUCTION
A liquidation preference right is a preferential right provided to financial investors, generally to secure their equity finance investments. Such a right (in its various forms) is generally provided irrespective of the stage of investment (be it a preliminary seed round of funding, or a growth stage funding round). What may differ is the manner of liquidation preference provided to the right holders.
'Liquidation Preference' is a right to receive a preferred payout in the event of liquidation of the investee entity or divestment of its assets, in priority to the remaining equity shareholders of the company. This payment is made after the payments to the creditors of the Company, who are statutorily required to be provided precedence in any such distribution of liquidation proceeds. A liquidation event typically includes, not just only winding up of the company or insolvency, but also the change of control events of the investee entity or group that is caused by merger, demerger and share sale or significant sale of assets of the investee entity or group.
II. TYPES OF LIQUIDATION PREFERENCE AND LIQUIDATION PREFERENCE ENTITLEMENT
Commonly, for ease of enforcement, liquidation preference right is provided to the holders of preferred securities, considering the preferred instruments are entitled to preferred payouts. Depending upon the terms of investment, the equity shareholders may also be provided with a liquidation preference on a contractual basis. The method of enforcing such a right provided to holders of equity shares may differ, in the event the liquidation is through a statutory process.
2.1. Participating and Non-Participating Liquidation Preference
Broadly, there are two kinds of liquidation preference rights, (i) participating liquidation preference, and (ii) non-participating liquidation preference.
In scenarios where a participating liquidation preference right is provided, the holders of such right will be entitled to receive the pre-determined preference entitlement in priority to the remaining shareholders. Further, after making payments to all such right holders, all the shareholders of the Company (including the right holders who received the preference entitlement) will be entitled to participate in the distribution of the remaining liquidation proceeds, in proportion to their shareholding. Hence, the right holders in such a scenario are entitled to a double dip in the available proceeds.
In scenarios where a non-participating liquidation preference right is provided, the holders of such right will be entitled to receive the pre-determined preference entitlement in priority to the other shareholders or their pro rata entitlement, as opposed to a double dip right as explained above.
All liquidation preference right holders can even have an inter-se agreement to decide the liquidation preference priority amongst themselves. The investors who invest in a company at an advanced stage and at a higher valuation generally have a lower shareholding percentage in the company, as opposed to early stage investors (who invested at a lower valuation). The later stage investors at the time of their investment may insist on a liquidation preference in priority to other right holders (who invested in earlier rounds). This would lead to what is generally referred to as 'a distribution waterfall' amongst the liquidation preference right holders. For example, consider a situation where there are 3 right holders (series B preference holder, series A preference holder and series seed preference holder) who have invested in the company at different valuations. In this case, (i) the series B preference holder has invested in the company at the highest valuation and holds the lowest shareholding percentage in the company, (ii) the series A preference holder has invested in the company prior to the series B preference holder, but after the series seed preference holder, and (iii) the series seed preference holder invested in the company at a very early stage, prior to both series B and series A preference holders. In this case, generally in a waterfall liquidation preference scenario, inter-se between the right holders, the series B preference holder will be paid-out in priority to the other right holders. After the payment to the series B preference holder, series A preference holder will get priority over the series seed preference holder, and after payment to the series A preference holder, the series seed preference holder will be paid. If any proceeds remain thereafter, the equity shareholders in the company will get the proceeds pro rata to their inter-se shareholding. However, if prior to the investment by the series B preference holder, the holder of series A preference shares and holder of series seed preference shares have agreed to have pari-passu liquidation preference between them and are agreeable to continue in the same manner as agreed earlier, then the distribution waterfall amongst the right holders will translate differently. In such a case, the series B preference holder will be paid-out in priority to the other right holders. After the payments to the series B preference holder, the series A preference holder and series seed preference holder on a pari-passu basis, will get a priority over the equity shareholders of the company. If any proceeds remain thereafter, the equity shareholders in the company will get the proceeds pro rata to their inter-se shareholding.
2.2. Liquidation Entitlement
In case of both participating and non-participating liquidation preference right, there are different kinds of preference entitlements that exist. Primarily, the right of liquidation preference is provided to protect the amount invested in addition to all the accrued or declared, but unpaid dividends, in the event of a liquidation of the company. In the event of a good liquidation scenario, the liquidation preference right will entitle the investors to receive an upside on their investment (over and above the investment). The manner in which the right holders will be able to secure their investment amount and participate in the receipt of an upside, depends on the manner in which the right is reduced to writing. In bad liquidation scenarios where the proceeds are not sufficient to provide the entitled preference amounts to the right holders, the rights holders shall have the preference such that the proceeds are distributed inter-se the right holders' basis their liquidation preference entitlement. In this context, it becomes very important to appropriately define the liquidation preference entitlement as per the commercial understanding.
Generally, there are two ways in which the right of liquidation preference is reduced to writing and the term 'preference entitlement' is defined. The most crucial part of drafting a liquidation preference clause is in defining 'preference entitlement', that indicates the priority is in relation to the payment of the liquidation amount. The following are the two scenarios.
(i) The first one being, where liquidation preference entitlement is defined as an amount that is equal to 100% (One Hundred Percent) of the original investment amount (plus all accrued or declared but unpaid dividends until the date of such payment) ("1x Amount"). This is then qualified by stating that if the amount per share held (on an as if converted basis1) through the pro rata participation in the proceeds of liquidation (after excluding 1x Amount above) is higher, then the liquidation preference right holder (other than whose 1x Amount is higher) can participate in such pro rata distribution when the remaining proceeds are distributed to the remaining shareholders (who do not have the right of liquidation preference).2 In simple words, liquidation preference right holders shall be either entitled to obtain their preference entitlement in preference to the equity holders or instead convert those preference shares or deemed to have converted those preference shares into equity shares and participate in the distribution of the proceeds pro rata to their shareholding ("Scenario 1").
In Scenario 1, for the right holder whose 1x Amount is higher than the amount they would receive by participating in the pro rata distribution of liquidation proceeds (basis their shareholding in the company on an as-if converted basis), would be paid such amount in priority to the other shareholders of the company. Post such payment, the remaining shareholders (including the holders of the right of liquidation preference whose 1x Amount was not higher) will participate in the pro rata distribution of the remaining liquidation proceeds.
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