One of the mechanisms employed to hedge investment risks in a private equity transaction is that of a liquidation preference. Extensive time is spent on structuring the liquidation preference while negotiating such investments. The meaning of a liquidation preference right is that when a "liquidation event" is triggered, the investor is entitled to receive an amount equal to or a multiple of its investment in preference over other shareholders. Such multiple could be double or more of the amount of the original investment. Waterfall provisions in an investment agreement provide for, the sequence in which different classes of shares have a preference. For example, Series A shareholders may be entitled to 3x their investment at liquidation and the holders of Series A shares shall have a first claim over the Series B shares, whose holders are entitled to 2x of their investment amount at liquidation.
It is recommended that preference shares be used as the instrument for the purpose of invoking a right of liquidation preference.
Under the Companies Act, 2013 and the surviving provisions of the Companies Act, 1956 ("Act"), share capital of a company is categorized into preference and equity shares. Preference shares are that part of a company's share capital which carry a preferential right to be paid dividend at a fixed rate or amount and repayment of capital in case of winding-up of the company. Hence under the Act, preference shareholders carry with them an inherent right of preferred distribution in the liquidation of a company.
Most investors include a participating liquidation preference that grants the investor a right to receive its funds in a liquidation event, with the balance of the proceeds being shared ratably amongst the holders of the equity shares and preference shares. In a non-participating liquidation preference, the preference holder will be entitled to receive its predetermined returns (as discussed above), but shall not be entitled to receive any portion of the surplus proceeds to be distributed to the equity shareholders. Preference shares are always deemed to be non-participating, unless stated otherwise by the articles of association.
In practice, an event of liquidation is not limited to "winding up", under the Act. It usually includes any merger, consolidation of the company in which its shareholders do not retain a majority of the voting power in the surviving entity, sale of all- or substantially all- of the company's assets and any other transaction constituting a change of control or even an initial public offer. This article examines the enforceability of liquidation preference provisions in the case of a winding up under the Act.
Winding up proceedings can be initiated through an application made to the court or in pursuance of a shareholders' resolution for voluntary winding up. The priority of repayment in the course of winding up is statutorily prescribed, such that shareholders may be repaid only after all outstanding liabilities of the company have been discharged. While the Act does not specifically provide that the liquidator or the court would be guided by the articles of association in winding up proceedings, it is recommended that the agreement on liquidation preference be incorporated in the articles of association of a company for the reasons below.
In case of a winding up by the court, the Act lays down that the liquidator shall, in the administration and distribution of the assets of the company, have regard to the directions that may be given by the resolution of the creditors or contributories (shareholders) at any general meeting, or by the committee of inspection that is formed under the mandate of the court (with the former overriding the latter in case of conflict). Further, the Act provides that the court has the power to adjust the rights of the contributories among themselves and distribute any surplus among the persons entitled thereto. Similarly, in a voluntary winding up, the Act states that subject to the sequence of payments, the assets shall be used to satisfy its liabilities pari passu and thereafter, unless the articles of association of the company otherwise provide, be distributed among the members according to their rights and interests in the company.
It would, therefore, be prudent to include provisions pertaining to the liquidation preference in the articles of association.
With respect to premium paid by shareholders, the Act states that the premium received on preference shares is represented in the securities premium account. In Deputy Commissioner of Income Tax Vs Maipo India Limited, it was observed that on a winding up, the surplus monies in the securities premium account were to be returned to the shareholders as capital.
It is possible to have various classes of shares carrying differential rights to receive liquidation proceeds. The Act specifically allows for different classes of equity shares. However, companies are required to comply with the conditions contained in the Companies (Share Capital and Debentures) Rules, 2014 which include, among others, having a consistent track record of distributable profits for the last 3 years. To encapsulate, the provisions relating to liquidation preference must be incorporated in the articles of association. Once enshrined in the articles, the liquidator would be guided by the rights of the shareholders set out there in accordance with the winding up provisions of the Act. It is also recommended to use preference shares to seek specific statutory protection accorded to them in the event of a winding up.
In our experience, we have generally seen that both the promoters and the investors negotiate aggressively on the liquidation preference provision. However, there are no reported cases of such a provision actually being used to exit and provide a return to an investor in a winding up.
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.