A liquidation preference clause is usually incorporated in investment agreements with a view to protecting the investment made by the investors in companies, upon the occurrence of certain events. A liquidation preference, in general terms, means the order in which payments shall be made during the event of corporate liquidation. This clause is incorporated in the investment agreement to ensure that the investors are paid prior to the making of payments to promoters and other common shareholders in a liquidation event. Liquidity event as defined in the investment agreements usually includes any merger, acquisition or sale of voting control of the company or a sale, conveyance or other disposition of all or substantially all of the property, assets or business of the company etc.
B. SIGNIFICANCE OF LIQUIDATION PREFERENCE:
In an investment agreement, various exit mechanisms are provided to the investors under various clauses upon the completion of stipulated timelines as mentioned under the agreement. However, a liquidation preference clause gets triggered upon the occurrence of liquidation events, before the investor exits and provides protection to the investor by way of providing the investor with his investment amount on a preferential basis before making any such payment to other shareholders of the company.
C. TYPES OF LIQUIDATION PREFERENCE:
1. Non-Participating Liquidation Preference:
In this form of liquidation preference, the investors shall not be entitled to any form of surplus proceeds provided to the equity shareholders but shall only be entitled to the predetermined amount of return, with respect to the investment made in the company or pro-rata amount based on the shareholding percentage in the company, whichever is higher.
2. Participating Liquidation Preference:
Under this form of the liquidation preference, along with a predetermined amount of return, the investor shall also be entitled to receive the surplus proceeds, available to the other equity shareholders of the company. Thus this type of participating liquidation preference provides the investor extra protection by way of providing the proceeds from the surplus available to the common shareholders. This is also known as double-dip and is not in favour of the promoters but is inclined towards favouring the investors.
C. OTHER IMPORTANT ASPECTS OF LIQUIDATION PREFERENCE CLAUSE:
The amounts payable to the investors would differ based on the transaction and its complexity. The distribution of proceeds can be done in various ways as mentioned above. It may also be a multiple of the investment amount as may be negotiated by the investor and the company, upon the occurrence of a liquidation event, which is generally 1X, 1.25X, 1.5X, 2X etc of the amount of investment. The multiple of the investment amount becomes payable to the investor by the company. Investors usually consider the option of a non-participating liquidation preference with a higher multiple to get a return in the case of a liquidity event. In most of the deals in India, the investors have preferred the 1X multiple i.e. to receive that amount which is invested in liquidation events.
There are certain situations in which the investor is provided with an option to choose the liquidation preference method, on the occurrence of a liquidation event. The investor can choose the option which would provide him with high proceeds. Usually, it is common that all the investors have equal rights to participate in case of liquidity event. However, in some instances, it has also been seen that the investor who has invested last in the company has a first preference upon happening of a liquidity event.
D. ENFORCEABILITY OF LIQUIDATION PREFERENCE CLAUSE:
Upon the perusal of the provisions of the Companies Act, 2013, preferential rights are usually provided to preference shareholders, over and above the equity shareholders. Equity shareholders are considered to be the risk bearers and preference shareholders are to be paid off before the payment of equity shareholders during liquidation or winding up. The preference shareholders are provided with the preferential right with respect to the payment of premium and other amounts in accordance with Section 43 of the Companies Act, 2013 and such rights have not been provided to equity shareholders. However, in the event the investors have subscribed to the equity shares of the company, according to the concept of preferential rights, the preference shareholders are required to be paid off prior to the payment of equity shareholders i.e., the investors in such a scenario. A notification was issued by the Ministry of Corporate Affairs as on 5th June 2015 (“MCA”), providing an exemption to private companies under Section 43 of the Companies Act, 2013 and it required that the articles of association of the company shall clearly state that the company is exempted under Section 43 of the Companies Act, 2013.
By placing reliance on the aforesaid, it can be clearly deduced that vide the aforesaid notification of the MCA, and with respect to incorporation of the statement in the articles of association of the company, that the private company is exempted under Section 43 of the Companies Act, 2013, the liquidation preference clause can be enforceable. To avoid any ambiguity and confusion with respect to the enforceability of the exit rights, the same shall be clearly incorporated in the articles of association of the company. However, the Companies Act, 2013 does not expressly prohibit the enforceability of a liquidation preference clause.
Under the Insolvency and Bankruptcy Code, 2016 (“IBC”), when a corporate insolvency resolution process is initiated against a corporate debtor i.e. the company, a moratorium is declared under Section 14 of IBC. Once a moratorium has been declared, the transferability of assets comes to a standstill and in such a scenario the enforceability of the liquidation preference clause is not possible. Upon the filing of a resolution plan by a resolution professional and upon the plan not being approved, then the corporate debtor goes into liquidation and under Section 53 of IBC, through the waterfall mechanism, dues are paid off. Preference shareholders and equity shareholders are paid off second last and last respectively. However, in such a situation also, the enforceability of this clause becomes difficult.
While considering the concept of the liquidation preference, it shall be essentially kept in mind that the interests of both the investor as well as the shareholders of the company are taken into consideration. This clause is incorporated extensively in investment agreements and should be thoroughly negotiated to keep in view the balance of interests of the shareholders, promoters and the investors.
Authors: Anita Dugar, Senior Associate; Kriti Sanghi, Associate.
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Updated as on April 24, 2020
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