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Liquidation Preferences: Demystifying Investor Protection in VC & PE Deals

In the complex landscape of venture capital and private equity transactions, the inclusion of various protective provisions is crucial to safeguard the interests of investors. One such provision that holds significant weight is the liquidation preference clause. This contractual safeguard ensures that investors have a certain level of protection in the event of a company's liquidation or sale. However, the enforceability of liquidation preference clauses is a nuanced topic, often requiring careful consideration and negotiation during the drafting of transaction documents.

So, what exactly is a Liquidation Preference?

Liquidation preference is typically defined in a company's shareholders' agreement to give the right to named investors to receive their investment amount plus a certain agreed-upon percentage of the proceeds in the event of the company's liquidation, in preference over other shareholders.

Liquidation preference is triggered upon the occurrence of a liquidation event. Agreements typically define this term to extend beyond the conventional understanding of the winding up or dissolution of a company, broadening its scope to include the sale of shares or substantial assets, an acquisition or merger of the company, and, in some cases, even a non-qualified IPO.

Now, understanding the nuances of Participating and Non-Participating Liquidation Preferences is essential. 

A non-participating liquidation preference gives investors the right to receive predetermined returns (their original investment back plus a fixed amount of money), but not a share of any remaining proceeds from the sale of the company. On the other hand, under participating liquidation preference, the investor, after receiving his pre-determined returns, shall also be entitled to participate (whether fully or to a limited extent) along with the equity shareholders in the distribution of the surplus proceeds.

In short, this means that if the company is sold for a profit, investors with participating liquidation preferences will receive more money than investors with non-participating liquidation preferences.

Moving on to the Waterfall Mechanism

A waterfall mechanism in liquidation preference is a structured distribution process used to determine how the remaining proceeds of a liquidated company are distributed among its various stakeholders, particularly investors holding preferred shares. It acts as a roadmap, outlining the priority and order of payment for each class of shareholder.

Section 53 of the Insolvency and Bankruptcy Code 2016 (IBC) sets out the waterfall mechanism for distribution of the liquidation proceeds: settlement of dues of debenture holders is the highest priority, followed by preference shareholders and lastly equity shareholders.

Recent Development: A new twist in the Waterfall 

On October 31, 2023, the Supreme Court of India dismissed the review petition of the September 2022 ‘Rainbow papers’ judgment (State Tax Officer vs Rainbow Papers Limited). The Rainbow Papers ruling creates scope for pushing government dues up the ‘waterfall’ from the fifth place to second place, on a par with secured creditors; this is because the apex court ruled that VAT payable by the entity provided the government with a charge on its assets. 

A Guide to Opt-out of Standard Waterfall

Traditionally, preference shares have been considered superior to equity shares in terms of repayment of capital and dividend distribution during a company's winding up. However, an exemption introduced by the Ministry of Corporate Affairs in June 2015 offers a solution for achieving different levels of investor protection. Private limited companies can now opt-out of sections 43 and 47 of the Companies Act 2013 by amending their Memorandum of Association (MOA) or Articles of Association (AOA). This allows them to create a differential class of equity shares with priority over preference shares in terms of capital repayment during liquidation.

The position of law in respect of liquidation preference rights pertaining to the holders of the same class of shares is that the liquidation proceeds would be paid in full or in equal proportion, contingent upon the sufficiency of such proceeds. For instance, if multiple investors hold the same class of securities without the company having created a different class of securities in its capital (for example, Series A equity shares, Series B equity shares and so on, which are basically ordinary equity shares), offering precedence to one investor over the other investor in such a case would not be considered to be in consonance with section 53 of the IBC. Therefore, to accord preferential treatment to an investor as per the liquidation preference arrangement, the investor should ensure that it holds a separate class of shares.

Conversion Rights and their Impact on Liquidation Preference Pay-outs

Conversion rights allow investors to exchange their convertible securities (preference shares or debentures) for equity shares. In the event of liquidation, investors with participating or hybrid liquidation preference rights are entitled to a portion of the proceeds based on their proportionate shareholding. Computation of such pro-rata shareholding is a cumbersome process in the case of securities that are convertible into equity shares. Therefore, it is essential to carefully negotiate the inclusions and exclusions in the definition of "fully diluted basis" or "as-converted basis" in the liquidation preference clause.

However, if a convertible security is converted into equity shares before a liquidation event, the investor may lose their priority status under the law, as they will now hold equity shares. This would make the liquidation preference arrangement redundant.

Understanding the Legal Landscape: Overriding nature of the Insolvency and Bankruptcy Code

While the liquidator appointed under the Insolvency and Bankruptcy Code (IBC), 2016 is not bound by the provisions of a liquidation preference arrangement outlined in the transaction documents by contracting parties, there is a perspective that the company and the promoters, as parties to the transaction documents entrenched in the articles of association, could be contractually bound by such liquidation preference provisions. This could provide the investor with a cause of action against the company and the promoters, necessitating due performance of the liquidation preference provisions.

Nevertheless, it is advisable to structure the liquidation preference clause in a manner that requires the promoters to compensate the investor for any deficit in the liquidation proceeds, following the distribution of such proceeds in accordance with the law.

Another crucial aspect to ensure is that while structuring a liquidation preference clause for a foreign investor, one must be cautious not to contravene pricing guidelines if the liquidation involves the sale of shares. This is because a liquidation preference arrangement, appearing to offer an assured or minimum guaranteed return to the investor, might be construed as providing a foreign investor with an assured exit. Consequently, this could violate the regulations set forth by the Reserve Bank of India.

Conclusion: The bottom line for the Investors

In conclusion, while liquidation preference arrangements offer crucial protections to investors, navigating their complexities requires careful consideration of legal nuances and strategic negotiation. Investors and companies must be aware of recent legal developments, explore different preference structures, and ensure compliance with pricing guidelines, especially in the case of foreign investors. A well-structured liquidation preference clause not only provides a roadmap for distribution but also establishes a contractual basis for potential legal action against non-compliance. This article serves as a comprehensive guide for stakeholders in venture capital and private equity transactions, emphasizing the importance of thoughtful negotiation and legal compliance in drafting transaction documents.

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