Understanding Liquidation Preferences

As an entrepreneur, one should not be too hung up on just valuations while negotiating with an investor. Important clauses in a term sheet, like the liquidation preference clause, require careful analysis by the promoters

We wrap up the investor-entrepreneur term sheet series with our last discussion clause on the term sheet, the liquidation preference clause. By the very term, the clause decides who gets preference during a non-IPO exit from the company. This clause is of very keen interest to a financial investor who needs to show returns to his limited partners (LPs) who invested in his fund. And by tagging the word liquidation to the word preference it means, that at the time of liquidation of the company the investor will exercise a preference as to what he takes home as a return for investing in the company.

For the numerically challenged, including me, here is simple illustration that does the trick of explaining this very nicely:

Pre-money valuation of the company: Rs. 20 crore
Money raised from an investor: Rs. 20 crore

Hence, post-money valuation of the company: Rs. 40 crore (investor holding is at 50 per cent and promoter is at 50 per cent) Let us assume the company sale price down the road: Rs. 35 crore

In this scenario, without a liquidation preference clause, the investor takes home 50 per cent of the pie (Rs. 17.5 crore) and the promoter the balance. Notice that the investor has lost in this investment but could have been saved from loosing out on this investment if he had inserted a liquidation preference clause in his term sheet.

The liquidation preference clause, decides what the investor takes home in such an exit scenario. The way the clause is drafted can either be pro-investor or pro-promoter. As an entrepreneur, one should pay careful attention to this very clause.

In a vanilla pro-promoter liquidation preference clause the investor will take home his principal PLUS will share pro-rata in the remaining sale proceeds the company receives. In a preference share investment round the investor would take his principal and then convert his preference shares to common equity which will entitle him to participate in the balance of the sale proceeds the company has received.

You could also have a, “capped participating liquidation preference” which is a notch more cumbersome. This is where the investor is assured of his principal plus the distribution proceeds in a pro-rata basis until a certain multiple that is pre-agreed between the two parties is reached. This one is also called ‘double dip’ for obvious reasons.

In the recent past, we have seen several promoters agree to lower valuations to negotiate a better liquidation preference clause. As always, in a term sheet negotiation, as an entrepreneur, it is a give and take scenario and it depends on the entrepreneurs/his advisors to trade smartly, analyse the different scenarios and how they could play out before making a call on the liquidation preference clause. Loose the valuation game a bit, if you’re going to win a good liquidation preference!

This article first appeared in Smart CEO and was authored by Aarthi Sivanandh.

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