Insolvency & BankruptcyCrafting Fair Liquidation Preferences: Striking a Balance Between Investor Security and Founder Rewards

 Introduction & Meaning of Liquidation Preference                      

In today’s business world of booming startups, founders often dream of selling their companies for substantial profits. However, the reality is that many walk away with much less than expected—or sometimes nothing at all. A critical clause in venture capital and private equity agreements that influences this outcome is the liquidation preference (hereinafter referred to as “LP” or “LPs”). This provision determines how the proceeds from a company’s sale are distributed among shareholders.

LP provision determine the order in which investors get paid back after a liquidity event. Provisions are designed to give downside protection in the event of a sale for less-than-expected returns.

It is a key provision in venture capital and private equity agreements that governs how the proceeds from a company’s sales are distributed among shareholders . The idea behind doing this is essentially to protect investors by ensuring their money is returned before any other shareholders.

How this works is that the LP clause states that in case the company gets sold after an investor has invested money into it, then the said investor will get paid first. This typically occurs at a 1x multiple, which, in theory, means that before anything else, the investor gets his exact investment.

However, multiples may also be included in LPs. A 2x LP, for instance, ensures that the investor gets twice as much as he originally invested before any remaining proceeds are distributed.

LP become most noticeable when a company is sold for less than anticipated. For example, an investor with a 2x LP on a 100-crore investment would collect all 200 crores on the sale of the company, leaving the founders with nothing.

LP can significantly affect the financial result for founders and other shareholders even though its purpose is to reduce the risk for investors. For an equal distribution of proceeds in the case of a sale, founders must carefully negotiate these conditions.

Types of Liquidation Preference

There are two primary types of LP:

• Non-Participating Liquidation Preference clause

In a non-participating LP, investors receive their initial investment amount (i.e. a 1x multiple) before any proceeds are distributed to common shareholders. After the investors have received their due, the remaining proceeds are distributed among the common shareholders.

For Example: If an investor puts 100 crores in a company, and the company gets sold for 150 crores, the investor will get his 100 crores first. The remaining 50 crores are distributed among the common shareholders, including founders and employees.

• Participating Liquidation Preference clause

In a participating LP, investors receive their initial investment amount (or a multiple of it) first. After they receive the invested amount, they also participate in the distribution of the remaining proceeds along with the common shareholders. This means they get their money returned, and then they share in the remaining proceeds and thus stand to gain a larger amount of money.

For Example: If an investor contributed ₹1,00,000 with a 1x participating LP for 20% ownership in the company. If a Liquidation Event generates ₹2,00,000, the investor would first receive ₹1,00,000 as their 1x LP. Additionally, they would be entitled to 20% of the remaining ₹1,00,000, which amounts to ₹20,000. In total, the investor would receive ₹1,20,000.

Multiples and Variants

LP are often expressed as multiples, such as 1x, 1.5x, or 2x. These multiples determine how much the investor is entitled to receive relative to their initial investment.

• 1x Multiple: The investor recovers exactly the amount they invested before any other shareholders receive proceeds.
• 1.5x or 2x Multiple: The investor is entitled to 1.5 or 2 times their original investment before any remaining proceeds are distributed.

Some agreements also include a capped participation clause, which puts a limit to the total amount an investor can receive under a participating preference. This cap helps to balance investors’ and founders’ interests by ensuring that investors cannot claim an outsize share of the proceeds.

Legal Implications of Liquidation Preference

LP has certain legal implications for both investors and the founders of the company.

There are legal implications related to the LP for investors as well as the company’s founders.

• Preference for payouts: LP are legally binding and enforceable provisions that ensure investors recover their investment before common shareholders receive any proceeds in the event of a sale, liquidation, or similar event. These clauses are included in investment agreements to protect investors’ interests and guarantee a return on their capital before any distribution is made to common shareholders.
• These provisions can significantly impact the financial outcome for founders and employees. In cases of high liquidation multiples or participating preferences without caps, common stockholders may not receive any cash or at best a small amount of cash. This can result in founders and employees, who often hold common stock, walking away with far less than anticipated.
• In case there are multiple layers of preference, for example, numerous funding rounds, or if the LP is big, founders and early shareholders may be grossly prejudiced. In worst cases, even when one’s company sells for millions of money, founders might get absolutely nothing out of that transaction or deal.
• In some instances, such LP may even breed disputes between classes of shareholders. This could imply that the interests of preferred-share investors differ from common shareholders or may create disputes in the terms of the sale or liquidation.

The law governing the LP is the Companies Act, 2013.  Section 43 of the said act deals with the concept of LP and preference share capital.

In the event of any dispute between shareholders, the court will carefully review the terms and conditions of the agreement and enforce them accordingly. Therefore, it is crucial for both founders and investors to have a meticulously drafted clause and thoroughly examine it before entering into the contract.

Negotiation Strategies

Founders can negotiate several attributes of LPs to protect their interests:

• This can be achieved by capping, or limiting the amount an investor can receive, ensuring that founders and other shareholders can benefit from the company’s sale. By setting a cap on the investor’s payout, founders and other shareholders are given a better opportunity to receive a share of the sale proceeds.
• Founders must keep in mind, how LPs could impact their equity and voting power, as these clauses can remarkably reduce or lessen their control over the company, so the founders must be very mindful while closing a deal with an investor.

Current Market Trends for Liquidation Preference

• Using Participating Liquidation Preferences More Frequently

As market uncertainty rises, particularly in unstable economic conditions, investor interest in participating LP is increasing. This preference enhances their potential returns by allowing them to recover their initial investment first and also share in any remaining proceeds.

• Larger Multiples in Liquidation Preferences

While the more traditional 1x LP remains common, larger multiples-1.5x or 2x, for example-are increasingly being requested by investors. Indeed, due to increased multiples, the investors may receive up to 150% or 200% of their initial investment back before any payout to other shareholders.

• Capped Participation Becoming More Common

Capped participation is becoming an increasingly popular solution to participating preferences’ issues. Even in cases when an investor has a participating choice, caps place a limit on the overall amount they can get. Preventing investors from claiming an excessive or prolonged percentage of the sale revenues, guarantees a fair share for founders and other shareholders.

• Legal and Regulatory Scrutiny

As the use of complex LPs clauses grows, there is more legal and regulatory scrutiny to make sure that these clauses are expressed clearly and understood by all stakeholders. This is essential to protect normal investors from harmful clauses that could affect their interests.

AMLEGALS Remarks

A LP are a crucial component of venture capital agreements and have a significant impact on the financial outcomes for both investors and founders. Anyone involved in startup funding or exist negotiations must have a solid understanding of current market trends related to LP.

Nowadays, the investor community has a penchant for Participatory Preference and higher multiples to safeguard their investment and potentially amplify their return. However, often, this comes at the cost of the founders. The LP provision itself ensures that even in the case of an exit or sale, the potential reward may be drastically cut down to size.

On the other side, there’s a growing trend toward more founder-friendly terms in certain sectors, where startups have stronger negotiating power. The use of capped participation is also on the rise, which helps strike a balance between protecting investors and ensuring that founders retain a fair share of the proceeds. The founders’ long-term interests are those of making sure that, fairly and neutrally, they get their proceeds accruing from hard work and success. Viewed in this light, negotiating LPs that are reasonable and balanced is quite essential. One should avoid any kind of aggressive investment terms that can leave the founders with next to nothing in any divesture or winding-up scenario.

For any query or feedback, please feel free to get in touch with rohit.lalwani@amlegals.com or falak.sawlani@amlegals.com