Liquidation Preference in VC Contracts. Does it really work?

By Team YS|8th Nov 2011
Clap Icon0 claps
  • +0
    Clap Icon
Share on
close
Clap Icon0 claps
  • +0
    Clap Icon
Share on
close
Share on
close

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

StatusEarlier ProvisionsRevised Provisions
a.Listed on stock exchangeTransfer of shares by way of sale, by resident to non-resident shall be at a price not less than the ruling market price.The price of shares shall not be less than the price at which a preferential allotment of shares can be made under SEBI guidelines.
b.Unlisted sharesThe price shall be as per fair valuation done by a chartered accountant based on guidelines issued by erstwhile Controller of Capital Issues.The price shall not be less than the fair value as determined by a chartered accountant or SEBI registered Category I merchant banker as per discounted free cash flow method.

-      Transfer of shares by Non-resident to Resident

StatusEarlier ProvisionsRevised Provisions
c.Listed on stock exchange-Prevailing market price if effected through SEBI registered merchant banker/ stock broker.-In other cases, the price arrived at by taking the average of daily high and low for one week preceding the date of transfer with a variation of 5%.- if the shares are transferred by foreign collaborator / promoter to the existing promoters in India with the goal of passing management control, then a premium of 25% to the above price is permitted.The price of shares shall not be more than the price as described in (a) above.
d.Unlisted shares-The price shall as mutually agreed between the parties, if the consideration is less than Rs. 2 million per seller per company.-If the consideration is above Rs. 2 million, then price based on EPS linked to P/E multiple, or a NAV linked to book value multiple, whichever is higher; or- at a price which is lower of the two independent valuation of shares, one by statutory auditors and the other by a chartered accountant / SEBI registered Category I merchant banker.The transfer price shall not be more than the fair value as determined by a chartered accountant or SEBI registered Category I merchant banker as per discounted free cash flow method.

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!

About NovoJuris

Sharda Balaji founded NovoJuris with the realization that technology innovations are fast outpacing the legal framework. NovoJuris counts over 200 small and medium business and over 10 investment houses as their customers over the last 3 years. NovoJuris values a culture of providing professional legal help and obsesses about the success of their customers. The management team at NovoJuris brings over 30 years of experience in technology and law into practice. Do check out their website for further details.

Get access to select LIVE keynotes and exhibits at TechSparks 2020. In the 11th edition of TechSparks, we bring you best from the startup world to help you scale & succeed. Join now! #TechSparksFromHome

    Clap Icon0 Shares
    • +0
      Clap Icon
    Share on
    close
    Clap Icon0 Shares
    • +0
      Clap Icon
    Share on
    close
    Share on
    close