Pretty much every institutional investor term sheet and shareholders' agreement would have a section titled "Liquidation Preference". Let's try to demystify Liquidation Preference ("LP").
No $ for you until I get my $$$ back in full
Yes! That's one way to understand LP. LP is downside protection for the investor in case the company is sold cheap. Upon investing, an investor would hold a certain percentage of ownership in the company.
In a simple world, if the company is sold, the investor would receive the percentage of the sale price which is equal to its ownership percentage in the company. But what if that percentage of the sale price is less than the capital invested by the investor? LP addresses this situation.
Under the LP clause, the investor has the right to receive the money it invested (or a multiple of that, depending on the commercial understanding) before any other shareholder receives any amounts. Let's see how LP works through some simple illustrations. (Please note that the illustrations are based on the current Indian market standard model for LP).
Suppose the investor invested 100 for a 10% ownership in the company.
A. The company is sold for 2500. The investor would receive 10% of the sale price or 250. The rest of the shareholders (i.e, owners of 90% of the company, including the founders) get 2250 pro rata (i.e., each shareholder's ownership percentage in the remaining 90%).
B. The company is sold for 250. Without LP the investor would have received 10% of 250, or 25. With LP, the investor receives 100. The rest of the shareholders get 150 pro rata.
C. The company is sold for 90. Here, LP allows the investor to receive the entire 90. The rest of the shareholders end up not receiving anything.
Let's say two investors invested 100 in 50:50 ratio (for a company ownership of 5% each). Here, the pay-out to the investor(s) will be split equally between the two investors in all three scenarios.
What if the two investors invested in different rounds (i.e., at different valuations). Investor "X" bought a 7% ownership in the company for its 50 and Investor "Y" bought a 3% ownership in the company for its 50. What would X and Y receive in the three scenarios above?
In A above, X would receive 7% of 2500 (or 175), and Y would receive 3% of 2500 (or 75).
In B and C above X and Y would share the pay-out in proportion to the respective amounts that they have a right to receive (i.e., 50 each, or each investor is entitled to 50% of the pay-out). Thus, in scenario B above, X and Y get 50 each. In scenario C, they get 45 each (50% each of the total pay-out in each scenario).
No $ for you until I get my $$$ back in full
LP is a standard and non-negotiable term in startup funding deals in the Indian market (as well as the US, western Europe and most other jurisdictions).
The prevailing market standard is LP protection of 1X of capital invested, and pari passu distribution to investors of various rounds.
- "1X" means the maximum amount an investor may take under scenarios B and C above is the amount of capital it has invested.
- "Pari passu" distribution means that amongst investors that invested in various rounds there are no priorities or preferences for distribution. This is opposed to a model where a later round investor has a preferential right to its money vis-à-vis the previous round investors.
Useful tip: Founders' and other non-investor shareholders' position (in terms of what they get paid in a company sale) does not change regardless of whether LP distribution is pari passu or preferential amongst the investors. But their position changes depending on the amount for which LP protection is given (i.e., 1X LP versus a higher multiple of the investors' capital).
Watch this space for the next instalment of Deal Terms Demystified. In the meanwhile, feel free to share this post with your friends and colleagues you feel would find this helpful.
Originally published 31 October 2019
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.