Understanding key terms in a VC term sheet - Liquidity preference

This article is in continuation to the term sheet series. The previous article can be found here https://www.linkedin.com/pulse/understanding-key-terms-vc-term-sheet-how-type-shares-chandran/

Generally, preferred shares have the following financial rights (Some of them are mentioned in the sample term sheet - https://www.startupindia.gov.in/content/dam/invest-india/Templates/public/Tools_templates/internal_templates/Lets_Venture/TERM_SHEET_EQUITY.pdf) :-

1.     Financial rights

a.      Dividend rights / right to dividends: - Rights to receive preferential dividends as compared to common shareholders. This can be a huge factor in company cash flow and the company needs to carefully consider what the appropriate dividend percentage is. Dividends can be cumulative or non-cumulative. In case of cumulative dividends, unpaid dividends are carried forward to next year and when the dividends are paid by the company, the total cumulative dividends of the preferred investors are released first and the remaining portion is distributed among common equity shareholders on a pro-rat basis. In case of non-cumulative dividends, the unpaid dividends are not carried forward and the company is under no obligation to pay the unpaid dividends to the preferred shareholders in subsequent years.

Combining the type of preferred shares there could be 6 scenarios of dividend distribution

1.     Non-convertible non-cumulative

2.     Non- convertible cumulative

3.     Simple convertible non-cumulative

4.     Simple convertible cumulative

5.     Participating convertible non-cumulative

6.     Participating convertible cumulative

You would have realized that the most favorable dividend option for entrepreneur is paying non-cumulative dividend on Non-convertible preferred shares & the most investor-friendly option is having Participating preferred shares with cumulative dividend rights for the investor(s).

Furthermore, one could also have the option of receiving dividend in the form of shares or cash. As a budding start-up with liquidity concerns, if your investor is negotiating for a dividend, you can always present the option of distributing dividend in the form of the latest / earlier Series of shares at the original purchase price / latest purchase price. The result will be that the investor shall receive shares equal in value to the dividend declared by the Company. This clause can be included in the term sheet accordingly.

b.     Liquidation preference (Given in term 2.11 of the sample term sheet ) – As this term indicates, this preference in applicable in case of company liquidation, merger, sale, buy-out or due to bankruptcy proceedings. During any such event, the company is expected to receive lump sum consideration in the form of cash or other asset classes. Liquidation preference determines the methodology by which the existing shareholders of the company are compensated during such liquidation events. The holders of preferred shares always have preference to common equity shareholders with respect to the proceeds from liquidation events.

Let us see how the clause is structured in the sample term sheet

Subject to applicable law, the holders of Equity Shares shall have preference over other equity shareholders (“Liquidation Preference”) to distribution from the Company or from other third parties, as the case may be, upon the occurrence of a liquidation event (as described in the Definitive Documentation) and shall be entitled to receive in preference to the holders of other equity shares, an amount which is equal to either: (a) the pro-rata share of the Investor’s shareholding on as if converted basis plus all declared but unpaid dividends; or (b) the Investment Amount plus all declared but unpaid dividends, whichever is higher. Transactions constituting liquidation event shall be detailed in the Definitive Documentation

The section in bold mentions the share of liquidation proceeds which the preferred shareholders are eligible to receive. Based on the option given we can understand that the preference share is a simple convertible preference share.There are basically two options for the investor,

• Either convert her preferred shares to common shares based on conversion ratio and obtain the pro-rata share of proceeds plus unpaid dividends or 
• Continue to hold her shares as preferred shares and take her initial invested amount plus unpaid dividends

Now, what the investor shall choose depends on the total quantum of the liquidation proceeds. If the proceeds are less the amount invested by the investor, she will not convert into common equity. However if the quantum of proceeds is high and on conversion to common equity she stands to gain more than her initial investment, she shall convert. This scenario can be represented by the following graph

We have considered that the investor has invested INR 10 Crore for 25% holding in the company & the X-axis represents the total liquidity proceeds. Based on the liquidation preference given above two scenarios emerge:-

1. Investor can hold preferred shares & stake claim on the proceeds to recover her invested amount OR
2. Convert into ordinary shares & stake claim on the proceeds based on % ownership (This will be 25% ownership considering 1:1 conversion)

Till the total liquidity proceeds are INR 40 crore, the investor is better off not converting into common equity. But beyond INR 40 Crore, there is a definite incentive for the investor to convert into common equity & participate in the upside.