Simply put, it is the preference towards exit pickings for each class of shareholders in a company in the event of a strategic exit or sale for the shareholders. The Liquidation Preference clause and the waterfall it ensconces is a watershed provision in all term sheets and investment documents that usually decides who walks away grinning to the bank or otherwise.
Since a company chiefly bears exit returns to its shareholders and investors either through an IPO (which is when all private contractual agreements governing classes of securities fall away) or pre IPO sale of business, it is imperative for an investor to pre determine what component or percentage of the sale proceeds it will be entitled to when the cash is counted.
Picture a liquidation preference waterfall as exactly that; a waterfall that cascades upon each class of shareholder in a company, bestowing it with a pre-determined cash component as it flows onwards to the next level of shareholders waiting below.
This is how liquidation preference clauses work (with the following assumptions):
- 1 investor coming aboard the Company and investing Rs. 10 crores — the pre investment valuation of the Company is Rs. 30 crores — therefore the post money valuation of the company is Rs. 40 crores — the investor now holds (10/40) 25% of the Company.
The way you would structure the Liquidity Preference conversation would ideally be diametrically opposite if you were an Investor vis-a-vis a promoter. To understand this better from a practical play out, here are a couple of permutation-combinations that the investor and promoters could agree upon in their investment agreements. The scenarios are purely indicative permutation-combinations and there are, understandably, a number of ways these could be structured such as multiples on principal amounts invested, ceilings on the amount of participation and the like.
In a Rs. 100 crore Company sale, this is what the Investor would make:
(i) 1x of investment amount (i.e. Rs. 10 crores) + 25% participation in what is left (Rs. 22.5 crores); OR (ii) conversion of 25% of its shares from Preference to Equity and thereby taking up 25% of the Rs. 100 crore sale (i.e. Rs. 25 crores).
As is evident, the Investor would choose option (i) and take home Rs. 32.5 crores.
(i) 2x of investment amount (i.e. Rs. 20 crores) + no participation in what is left; OR (ii) conversion of 25% of its shares from Preference to Equity and thereby taking up 25% of the Rs. 100 crore sale (i.e. Rs. 25 crores).
Here, the Investor would choose option (ii) and take home Rs. 25 crores.
(i) 2x of investment amount (i.e. Rs. 20 crores) + 25% participation in what is left (Rs. 20 crores); and (ii) no option to convert its shares from Preference to Equity.
With no second option to choose from, the Investor would go home with Rs. 40 crores, effectively a return of 400% on its investment.
An unlikely Scenario D:
Conversion of its Preference Shares into Ordinary Shares and participation in the Rs. 100 crore exit as a 25% shareholder.
Another fallacy a lot of entrepreneurs subscribe to is that of sky-scraping ‘valuations’. The online fraternity is today seeing entry point corrections rapidly and the valuation bubble has well-nigh already burst in terms of sinking money into valuation numbers that are larger than life. While it is always flattering to hear that the business you’ve created has great numerical prospects to an investor’s eye, consider the math below.
Assuming the following again:
- 1 investor coming aboard and investing Rs. 10 crores — the pre investment valuation of the Company is Rs. 20 crores in Scenario A and Rs. 40 crores in Scenario B — accordingly, the post money valuation of the company is Rs. 30 crores and Rs. 50 crores in the two scenarios — the investor therefore holds either 33.33% or 20% of the Company.
Here is what the Investor would make:
Scenario A: Pro Investor
(i) 2x of investment amount (i.e. Rs. 20 crores) + 33.33% participation in what is left (Rs. 26.66 crores) = a total of Rs. 46.66 crores; OR
Scenario B: Pro Promoter
(ii) 2x of investment amount (i.e. Rs. 20 crores) + 20% participation in what is left (Rs. 16 crores) = a total of Rs. 36 crores; OR
An unlikely Scenario C:
Conversion of its Preference Shares into Ordinary Shares and participation in the Rs. 100 crore exit as a 33.33% shareholder or a 20% shareholder.
Bearing the above in mind, a suppressed valuation at the time of investor entry (while yielding a lower IRR to the investor) may turn out to be an inconsequential number in the company’s eventual buyout/exit since the valuation will be considered on that present date and historic valuations are usually relegated to insignificance. From a promoter stand point, if the business is doing well there will likely be higher valuations and further capital infusion by the same/new investors. Given that a promoter usually only has finite capital/appetite to boot-strap the business and is typically diluted in these situations, an alternative may also be to hedge one’s bets and sell some equity directly to the new-money investor to avoid future uncertainties.
Legally speaking, it is sticky trying to contain liquidation preference arrangements within the pricing guidelines of the Foreign Exchange Management Act, but that is another story by itself.
Author — Sahil Vohra, General Counsel at Smile
Originally published with The Economic Times.