Drafting 1x Straight Liquidation Preference Right- Not So Straight

Introduction

An increasingly common way of articulating 1x straight liquidation preference (LP) clauses in agreements related to early-stage venture deals is some variation of the following language - "The investor shall be entitled to receive, prior to and in preference to any distribution of the proceeds of the Liquidity Event to any other Shareholders, the higher of (a) an amount equal to 1X of the amounts invested by the investor; and (b) the investor's pro rata entitlement on an as if converted basis". This article argues that the above construct adds complexities in the later rounds and also has the potential to prejudice the interests of the very investors it seeks to protect.

This article is divided into three main sections- the first section gives a brief introduction to the concept of liquidation preference in general, and 1x straight liquidation preference in particular. The second section considers a couple of simple scenarios to illustrate how 1x straight liquidation preference (should) work in those scenarios. The third section discusses the legal language under consideration and provides a hypothetical scenario to illustrate one potential pitfall of applying such language literally. Based on these discussions, the conclusion as mentioned above in the introductory paragraph is drawn.

Section 1- liquidation preference right explained

A liquidation preference clause details the preferential treatment to be given to the investors' shares while distributing the proceeds available upon the occurrence of a 'liquidation event'- a liquidation event typically covers not just actual winding up of the company but also covers events such as sale of the company or substantially all of its assets.

Preferential treatment is valuable when there is scarcity. In case of a successful 'WAGMI' (we are all gonna make it) exit, you will be fine to stay in queue and get whatever your pro-rata entitlement is, based on your shareholding in the company. But if it is a fire sale, and you are to be treated as a 'commoner', there may not be any proceeds left to give you when your turn comes. Liquidation preference ("LP") mitigates this risk.

There are three main attributes to an LP clause- a multiple, participation and seniority. Let's understand these in the context of the dominant form of LP in Indian VC deals- namely, 1x straight pari passu LP.

In this case,

• 1x represents the multiple, and denotes that the investor has a preferential right to receive (1 time) their investment amount in case of a liquidation event.
• The 'straight' clarifies the non-participation nature of LP, whereby once the investor has received its 1x investment amount as LP, that investor will not be entitled to any portion of the remaining proceeds which the company distributes to its other shareholders based on their pro rata shareholding.

To clarify, this does not mean that an investor's upside is capped at 1x; if it is a good exit, the investor always has the option not to exercise the liquidation preference afforded by the preference shares it holds and instead convert those shares into equity shares and participate in the proceeds pro-rata to their shareholding.

Sometimes, we like to have our cake and eat it too- participating preference share is in a way, a version of that philosophy. If the LP right is participating, investors would get their agreed LP right and get their pro-rata share when the proceeds remaining after giving effect to the LP rights are distributed.¹

• Seniority clarifies the priority among the different series of preference shares. For instance, in a standard seniority structure, for a company which has raised Series C round, distribution in a liquidation event will be first made to the holders of Series C Shares, then Series B, and then Series A Shares.

However, if the LP right is given on a pari passu basis, the holders across all series will have the same priority/seniority. Thus, in the event the distribution proceeds are insufficient to return the capital amount to all of the investors, the available proceeds will be distributed among all the shareholders pro-rata to the total capital invested.

A 1x straight LP is often the preferred via media position because it provides the investor with some downside protection while being fairer to the equity/common shareholders (typically founders) - thus, if the company manages a good exit, everyone gets their due share based on their pro-rata shareholding.

Section 2- Illustrations applying 1x straight pari passu LP

Let's apply the above principles to a few hypothetical scenarios. Let's assume an Investor 'A' has made a million-dollar investment and received preference shares equal to 10% of the share capital (on an as-if converted basis) in the company for such investment. The shares it holds have 1x straight pari passu LP rights.

Scenario A:

• Liquidity Event is for USD 1,000,000: If the investor converts its preference shares and participates along with the equity shareholders, it will get 10% of the proceeds - USD 100,000. Whereas, if the investor remains as a preference holder, it will get 1x preference and would accordingly receive USD 1,000,000:

In this case, Investor A, acting rationally, will choose to exercise its LP.

Scenario B

• Liquidity Event is for USD 11,000,000: If the investor converts its preference shares and participates along with equity shareholders, it will get 10% of the proceeds - USD 1,100,000. Whereas, if the investor remains as a preference holder, it would get 1x preference and would accordingly receive USD 1,000,000.

In this case, the investor would convert into equity/common shares and will not rely on the preference right attached to the preference shares.

Let's now introduce another Investor 'B' into the picture- investor 'B' has invested USD 2,000,000 and holds 10% shares on an as-if converted basis with the same 1x straight pari passu LP rights as Investor A.

Scenario C

• Liquidity Event is for USD 1,000,000: In this case, the proceeds are insufficient to give both Investor A and B their 1x LP, and accordingly, the available USD 1,000,000 will be distributed to A and B on a pari-passu basis pro-rata to the capital invested (and not their shareholding percentage). Thus, 'A' will get 1/3rd of USD 1,000,000 and 'B' will get 2/3rd of USD 1,000,000.

Scenario D

• Liquidity Event is for USD 30,000,000: If Investor A and B convert their preference shares and participate along with equity shareholders, each A and B will get 10% of the proceeds - USD 3,000,000. If only one of the investors converts, the converting investor would get, on an inter se pro-rata basis with the equity shareholders, the proceeds remaining after giving LP to the non-converting investor. Whereas, if the Investor A/B remains as a preference holder, it would get 1x preference and would accordingly receive only USD 1,000,000/USD 2,000,000 respectively.

In this case, both the investors would convert into equity/common shares and will not rely on the preference right attached to the preference shares.

As such, there would be a threshold where the investor would be indifferent between taking the LP preference and getting their pro-rata share, and beyond such threshold, the investor will always convert and take their pro-rata share (and below such threshold, the investor will never convert and will take their 1x LP). Compelling an investor to give up the LP and participate pro-rata with other shareholders in a good exit scenario is thus a 'feature' of 1x straight LP construct which makes it commercially fairer compared to other variants of LP clause.

Section 3: Examining the drafting language

The language at times employed to express 1x straight pari passu LP takes the following form:

The holder of the Series [A] Shares shall be entitled to receive, prior to and in preference to any distribution of the proceeds of the Liquidity Event to any other Shareholders, the higher of the following: (a) an amount equal to 1X of the amounts invested by them towards the subscription of Series [A] Shares, or (b) entitlement basis their pro rata shareholding in the company on an as if converted basis.

What stands out in this articulation is that there does not appear to be a price threshold at which an investor would convert their preference shares to equity. Since the LP itself entitles them to their pro-rata entitlement, there is no incentive to convert and give up its LP right in a good exit. At first glance, this distinction may sound like a 'tomato-tomato' difference in the early stages, where there is only one investor or multiple investors with same LP rights. Investor 'A' which introduces a language like the above might think they are in a stronger position with the said language rather than the standard/alternate articulation of the 1x straight LP right.

However, things start to get tricky in the later rounds when an incoming investor requests standard seniority. If, until that stage, everyone has assumed that the then-existing liquidation preference language in the SHA reflected 1x straight pari passu language, the incoming investor will mostly maintain that language and only change one attribute- replacing pari passu basis with a standard seniority. Accordingly, in the next round, the LP language above could get amended as below:

Firstly, the holder of the Series [B] Shares shall be entitled to receive, prior to and in preference to any distribution of the proceeds of the Liquidity Event to any other Shareholders, the higher of the following: (a) an amount equal to 1X of the amounts invested by them towards the subscription of Series [B] Shares, or (b) entitlement basis their pro rata shareholding in the company on an as if converted basis.

Secondly, subject to the holder of Series [B] Shares being paid their entitlement as per the paragraph above, the holder of the Series [A] Shares shall be entitled to receive from out of the remaining proceeds, prior to and in preference to any other distribution of the remaining proceeds of the Liquidity Event to any other Shareholders, the higher of the following: (a) an amount equal to 1X of the amounts invested by them towards the subscription of Series [A] Shares, or (b) entitlement to the remaining proceeds basis their pro rata shareholding in the company on an as if converted basis.

Let's examine the implications for early stage investors when that happens, with another example.

Scenario E

Let's take the last Scenario D and change only the seniority attribute from pari passu to giving standard seniority to Investor B over Investor A. Let's assume that the LP right is articulated in the manner provided in Section 3 (i.e. 'higher of 1x or pro-rata' construct).

• Liquidity Event is for USD 30,000,000: In this case, 'B' has a seniority and will accordingly get 10% of the proceeds first. Investor A will get only 10% of the remaining proceeds- USD 2,700,000* as against the USD 3,000,000 it would have received had it been a 1x straight LP with standard seniority.

(* This is if we apply the language extracted in Scenario D above literally.)

Given how the language is drafted, both the investors will get their pro-rata entitlement since it's higher than their respective investment amounts. However, given that Investor B has seniority, it will get paid its pro-rata first (and not just the 1x investment amount) and only then would the LP right of Investor 'A' kick in. If instead of the above language, the LP clause had merely stated that Investor B would have priority over Investor A to receive 1x of the amount invested to subscribe to the preference shares, Series B investor would have chosen to convert its preference shares to equity shares in order to receive the pro-rata entitlement, in which case both Investor A and Investor B would have received a 3 million payout each.

Of course, it is possible to address this potential risk in other ways- in the instant case, it could be clarified that for the purposes of determining the amount of the remaining proceeds payable to a shareholder which ranks lower in the liquidation waterfall, all the securities with senior LP outstanding in the share capital would be disregarded in calculating such shareholder's pro rata shareholding on as-if converted basis. However, sometimes, parties fail to consider and address all of the complexities that come with "higher of 1x and pro-rata" construct in later rounds.

Conclusion

In Scenario E above, we saw that Investor A which articulated 1x straight pari passu LP language as a "higher of 1x and pro-rata" construct was prejudiced in the later round when the same language was used as the basis for giving 1x straight seniority LP to the incoming investor. To be sure, Investor A here did not receive a lower amount because of the seniority right of Investor B, but rather because the seniority right was embedded to a language which said that the LP right is "higher of 1x and pro-rata" instead of merely stating that the LP right is 1x of the investment amount.

If you are an early stage investor or a founder, please consider if you might be better off with the alternate/standard articulation of 1x LP language (namely, LP is equal to 1 time the subscription amount/investment amount) rather than the "higher of 1x and pro-rata" construct. Should you choose to have the more complex "higher of 1x and pro-rata" construct, greater attention should be paid to the actual language in the agreement in the later rounds so that the agreement reflects the commercial intent.

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Footnotes

1. For the purposes of this article, discussion on the sub-category of capped and uncapped participating liquidation preference has been omitted.

2. For simplicity, it is assumed here that both the investors will convert to equity. Even where LP clause is drafted in the standard/alternate manner as suggested in the article, where one set of investors exercise their basic LP right, there could still be confusion as to whether one should distribute the remaining proceeds on an inter-se pro rata basis or the actual shareholding percentage, unless these aspects are clearly clarified in the liquidation preference clause in the agreement.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.