What In The World is Liquidation Preference?

11 April, 2011

I am a fairly easy-going guy and feel fairly strongly that I need to live up to my name (and as such, have a fairly high threshold for pain, anger and frustration). Having said that, there are certain unintended consequences of Indian regulations that make life for investors somewhat painful. I will focus on only one of them today. There is a fairly well-known and well-understood clause in any given term sheet, which refers to something called liquidation preference. The concept, for those who are unfamiliar with it, is simple enough. It means when a company is liquidated or sold, the investors get their money back and then usually investors (preference shareholders) and management (common shareholders) participate, according to their pro rata.


Here is a simple example. Let us assume that investors invest $5 million into a company in a series A for 25 per cent of the company ($20 million post-money valuation). Let us say the company does not do that well and for a variety of reasons, has to be sold for $10 million. According to the well-understood norms, the investors get their $5 million out first and the remaining $5 million gets distributed according to the pro rata holding ($1.25 million for investors and $3.75 million for management). But in India, the concept of liquidation preference is very different. First of all, even if there is language indicating the above math in the actual definitive agreements, that understanding cannot be enforced in India (unless the promoter/entrepreneur is looking out for the investors’ interest, rather than his/her own). So, let us run the math the way it would be done in India. Again, the company is sold for $10 million, the investors get $2.5 million (25 per cent) and the management gets $7.5 million. So, in effect, it makes sure that the investors lose money; yet it’s a minor windfall for the promoters/management.


The same concept applies to VCs themselves. Typically, when limited partners (LPs) invest in a VC fund of say $100 million, the deal terms are fairly standard. The VC is responsible for first returning the capital to the investors ($100 million) and then there is a profit-sharing arrangement beyond that (typically 20 per cent for the VC partners and 80 per cent for the LPs). The industry would not exist if the VCs start taking 20 per cent of every dollar being returned from the outset, without actually returning the invested capital first. It simply makes sense.


I have just been in a transaction described in the second paragraph above, causing me to seriously rethink whether I would want DFJ to invest in a true India Private Limited at all. I realise that it may be a bit of an over-reaction, but clearly to the extent possible, my recommendation to the partnership will be to invest in overseas (Cayman, Mauritius, Singapore, US) entities with a wholly owned India subsidiary, rather than directly into an Indian company, to mitigate the regulatory and enforcement risks that exist in India. There are also other regulations (which I will write about in other submissions) that also cause headache, not only because of their unintentional consequences, but also because several of these regulations keep changing every six months, therefore creating massive overhead and confusion. I also hope that the VC organisations through GIVCA and other entities will gather momentum to try and educate the regulators on the costs and benefits of certain regulations, as well-intended as they may be.

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What In The World is Liquidation Preference?

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