Must-know legal tips for startups by legal experts at NovoJuris
Liquidation Preference, simply put, is a term used in venture capital contracts to specify that the investors get paid in preference to other parties. The shareholders agreement (SHA) describes how much they get paid and in preference to whom.
SHA, typically also captures a definition of Liquidation Event. In most cases, it is defined pretty wide to include winding up, consolidation, merger, sale of more than 50% (this percentage varies) of shares, change in control and the like.
Some of the variants of the liquidation preference clause that you generally see in early stage funding are single dip or double dip. Here’s an example. Let us assume an investor invests $2 million into a company for 25% of the company and there is an exit at $10 million. Single dip would mean that of the $10 million, the investor gets his 25% and the rest goes to other shareholders i.e. the money gets distributed according to the pro-rata shareholding. Double dip would mean that investor gets his $2 million first (further variant could be 1x, 1.5x, 2x) and then the remaining $8 million gets distributed according to the pro-rata shareholding.
Most VC deals use preference shares as an instrument of investment. The Companies Act describes preference share capital as that part of share capital which carries a preferential right to receive dividend and capital, including a right to share in surplus assets in the event of a winding up.
The Companies Act, also has another section which details over-riding preferential payments should there be a winding up. At a high level, when the company is solvent, workmen dues and debts due to secured creditors shall be paid in priority to all other debts.
For obvious reasons, the investors would like to retain the preferential rights as long as they can and delay conversion to equity shares in order to protect their investment.
Further, in order to ensure that the SHA is enforceable in the Court of law, the SHA ingredients are restated in the Articles of Association.
Last year, under Foreign Direct Investment guidelines, Reserve Bank of India, revised the pricing guidelines.
I. Issuance Price: the price of shares issued to persons resident outside of India shall not be less than:
- As per SEBI guidelines if the company’s shares are listed on recognized stock exchange in India.
- If the shares are unlisted, then, fair valuation of shares done by a SEBI registered category I Merchant Banker or CA as per discounted free cash flow method.
II. However, the changes in the pricing guidelines for transfer of shares, preference shares and compulsorily convertible debentures, seem to be hurting.
Here’s a comparative of previous provision to the revised provisions. Please read the RBI guidelines for complete text. Here’sacopy.
- Transfer of shares by Resident to Non-resident
- Transfer of shares by Non-resident to Resident
While thankfully, there are no definitions of the applicable discount rate, growth rates, number of years of cash flow etc., the pricing guidelines is causing quite a stir in the VC community which might get affected during exits.
We are curious to know the outcome of the dialogue between IVCA (India Venture Capital Association) and RBI, if at all that happened.
What are your views on this article? Do let us know!
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