Liquidation Preference: How Effective is it?

In a column in the Economic Times, Amrita Singh and Siddharth Shah discuss the relevance of the concept of liquidation preference in Indian investment transactions:

“The progressive liberalisation of the foreign investment regime has provided a major boost to private equity and venture capital investments in Indian companies. With the advent of more sophisticated players in the private equity and venture capital arena, the deal terms also tend to get more complicated and sophisticated.

Many of the terms that are commonly employed in deals by these private equity players in other jurisdictions, may pose significant challenges in the Indian regulatory environment. In the context of deal terms and documentation, investor rights, and particularly provision for liquidation preference has always been an area of much debate and negotiation.

So what is liquidation preference? Liquidation preference is typically defined as the right of the investor (usually holding preference shares), to receive its investment amount plus certain agreed percentage of the proceeds in the event of a ‘liquidation’ of the company, in preference over the other shareholders. Contrary to a common perception equating ‘liquidation’ to ‘winding up’, ‘liquidation event’ is typically defined to include not only winding up of the company but also any ‘liquidity event’, which could include a sale of shares or substantial assets, an acquisition or merger of the company or in some cases even a ‘non-qualified’ IPO.”

They then go on to discuss various difficulties under the Companies Act as well as foreign exchange regulations when it comes to enforcing these liquidation preference clauses.

Although such provisions are becoming increasingly common in private equity and venture capital transactions, their enforceability has not been tested in the Indian context. Perhaps it is best if some of these aspects are clearly provided for in the Companies Act itself. The opportunity is likely to present itself soon for this purpose, as the company law is expected to undergo some change. A legal regime that facilitates investment transactions will aid the growth of private equity and venture capital (as Silicon Valley has proved in the latter case).

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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