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I. Terms of the deal for maximising return and minimizing downside

a. Instruments - equity, preference shares, and hybrid securities

When an investor invests in a company, he gets certain ‘securities’ of the company in return for his investment. Investors can subscribe to equity shares, preference shares or debentures, or ‘hybrid’ securities (which have characteristics of both equity and debt) issued by a company.

Let’s understand how an investor can benefit from ownership of different types of securities.

Equity: From the perspective of investing in an early stage company, an equity share is the riskiest form of investment (but also the most rewarding if the company does well) – since the company has no proven track record, if the company makes losses, the capital provided by equity shareholders can be potentially wiped out completely.

Strong performance by the company will lead to an improvement in the company’s valuation and hence an increase in the share prices. Performance may not be measured by financial metrics such as profits or revenues alone – it could be measured in terms of increasing customers, market share, etc. For example, YouTube was acquired by Google for USD 1.65 billion, and Instragram was acquired by Facebook for over 1 billion USD even when neither YouTube nor Instagram have revenues (click here for a story of other zero-revenue startups that were acquired for huge sums).

How important are profits for an investor?

Dividends will only be earned if the company does well.

Investors who have taken equity of made huge gains at the time of listing. For example, when Sequoia exited post IPO from Google, realized around 30 times their investment amount (their USD 12.5 million investment was realized for around USD 3.8 billion. See the link here.

Preference shares: Preference shares, on the other hand, are closer to debt. Preference shareholders get dividend (commonly called ‘interest’) in priority to the equity shareholders, but it is received only if the company has made profits. If the company does not make a profit, by default the interest will get accumulated and the preference shareholders will get all past accrued interest in the year in which the company eventually makes a profit. Preference shareholders are paid before equity shareholders.

Debentures: Debentures, on the other hand are pure debt, that is, a fixed amount of interest is paid on them, irrespective of whether the company makes a profit. Debentures provide the highest safety, in the sense that the company is still liable to pay interest on the due date even if it has not made sufficient profits. This safety may be insignificant compared to putting money in a fixed deposit account with a bank or investing in government bonds and securities, but is still higher than that of preference shares and equity. If the company fails to repay, its assets can be liquidated to pay off the lenders. Lenders will only lose money if the losses are so huge that the assets are insufficient to repay the loan amount and interest.

Hybrid securities: Subscribing to ‘hybrid’ securities (see below for details) is very popular, as they provide both a minimum level of security (with respect to income and principal amount) and the possibility of appreciation in value if the company does well. Before understanding how hybrid securities work, one must know the features of equity, preference shares and debt.

Equity shares (and preference shares) do not provide the income security of debentures, and debentures do not have the potential to appreciate in the same way as equity shares.

Therefore, investors have started investing in ‘hybrid securities’, that is, debentures or preference shares are convertible into equity. They may compulsorily convert at the end of a particular outer date, e.g. 5 years, or they may optionally be converted by an investor. Until they are converted, they have the properties of debt/ preference shares and yield a fixed amount of interest. Therefore, at the earliest stages, when the investor there is no proven track record of the company’s performance, an investor is relatively secure. Post conversion, there is significant scope for appreciation in the amount.  

Understanding debentures and advantages of convertible debt for investors


Examples of hybrid securities

1) A preference share or debenture with duration of 6 years which is optionally convertible into equity shares anytime, at the option of the investor. This is an optionally convertible preference share (OCPS) or debenture (OCD). If it is not converted within 6 years, the principal and the interest amount on the debenture will be repaid by the company, that is, the debenture will be ‘redeemed’.

2) A preference share or debenture which must compulsorily be converted into equity shares in 6 years by the investor. Such instruments will never be repaid by the company, that is, they are not redeemable. They will eventually be converted into equity shares. These are called compulsorily convertible preference shares (CCPS) or debentures (CCDs). An investor can, at his option (subject to the wording employed in the investment documentation) convert a CCPS or a CCD into equity at an earlier point of time as well.

NoteUnder the Foreign Direct Investment Policy, only compulsorily convertible preference shares or debentures are included within the ambit of foreign direct investment. Optionally convertible preference share or debentures are considered as debt and are within the ambit of external commercial borrowings (ECB) regulations (refer to the chapters on Foreign Direct Investment and External Commercial Borrowings in this module). This has a serious impact – the investment may not be permitted at all or it may be subject to a number of additional regulations if it is considered an ECB.

Measure of investor’s profits

An investor will make profits in the event that the company’s valuation has increased. The terms of issue of hybrid securities will have a specific conversion price (or alternately, a conversion formula, which determines the manner in which the price is to be calculated).

For example, assume that an investor paid INR 500,000 for 5000 compulsorily convertible debentures of INR 100 each. Next, assume that 2 debentures convert into an equity share of nominal value INR 100 each. Post-conversion the investor has 2500 equity shares. Thus, the conversion price for each share is INR 200. Assume that each equity share of the company is valued at INR 1000. That implies that the value of the investor’s money is INR 1000 X 2500 = INR 2,500,000, or five times the original investment amount.

Thus, if the investee does well, an investor can make a huge profit through hybrid securities.

  1. Liquidation preference
Liquidation preference (colloquially pronounced as lick pref) is a term used in venture capital contracts to specify that the investors must get their investment repaid upon ‘liquidation’ of the company in preference to other categories of shareholders. The objective of a liquidation preference clause is to provide venture capitalists from losing money by making sure they get their initial investment back before other parties. If the company is sold at a profit, liquidation preference can also help them be first in line to claim part of the profits. Venture capitalists are usually repaid before holders of equity shares (including the company's original promoters).

The meaning of liquidation under the SHA is of key importance – it does not merely refer to the winding-up of the company’s business but can refer to a variety of other situations which may not be bankruptcy-related events, such as merger, issue of a significant amount of shares, change in control, etc.

Investors do not seek only the investment amount (i.e. their capital) on liquidation – they usually seek a specific internal rate of return or IRR (which is similar to compound interest). For example, an investor could specify an IRR of 18 percent in the liquidation preference clause. In rare cases, the clause could even state that the investor will receive a multiple, such as 2x (twice) or 3x (thrice) the amount invested. When the investor subscribes to preference shares or debentures, he is entitled to the interest accrued and unpaid on the same. However, the liquidation preference multiple or the IRR percentage may be far in excess of such interest.

Similarly, when an investor makes an equity investment into a company – he is subject to ‘equity risk’, which includes risk of loss on the capital invested. To the extent that the liquidation preference or the IRR percentage are in excess of the amount actually accrued on the preference shares or debentures or is inconsistent with the nature of the equity investment, their legal validity (of both the IRR and the liquidation preference multiple) is uncertain.

The legal validity of both the IRR and the liquidation preference multiple is uncertain.
Further, any stipulation as to payment of IRR is subject to other limitations under company law, which prescribes an order of priority of claims of different categories of persons / entities – workmen’s dues, secured creditors, government dues salaries, social security contributions, unsecured lenders and debenture holders, preference shareholders and equity shareholders (see Sections 529A - 530 of the Companies Act).

For example, preference shareholders can get their outstanding capital and interest repaid in preference to equity shareholders only (but not in priority to debenture holders and other lenders). Hence, a liquidation preference clause will be valid only to the extent it does not override the rights of any other person or entity who has a prior right to claim its dues against the company.

Nevertheless, investment agreements often contain such clauses, even though they may not be ultimately enforceable. . In any case, when the startup is really not in a position to pay, investors realize that there is no realistic way to recover the amount due (unless the founders have been made personally liable under the investment agreement), so they do not insist on the entire amount due to them as per the liquidation preference multiple or the IRR figure.

Liquidation preference clauses are not merely used to minimize risk of loss - they can also be used to drastically increase gains for investors in the event of a profitable exit. At this point, it is more difficult for the shareholder to object to a higher payment being made to the investor (unless he is willing to involve himself in long-drawn litigation in courts). Consider the following example:

Let’s assume a startup is valued at INR 10 million by a VC before the investment. This is known as a pre-money valuation.

Assume a VC agrees to invest an amount of of INR 5 million. The total valuation of the startup (post the investment) will be INR 15 million. The VC, therefore, owns 5/15, i.e. 33 percent of the startup.

Assume there is an exit offer for INR 30 million.

Case 1

When there is no liquidation preference, the investor will simply get 33 percent of the consideration, that is, INR 10 million.

What is the return made by the investor?

As seen above, the valuation of the startup has doubled to INR 30 million from INR 15 million. The investment by the VC has also correspondingly doubled in value from INR 5 million to INR 10 million. The investor has made 2x of his total investment of INR 5 million.

Case 2

Consider a situation where the liquidation preference is 1x and the investor can participate in the remaining part of the exit.

In this case, out of the INR 30 million, the investor receives the first INR 5 million before any other shareholder receives any amount.

The remaining INR 25 million is distributed proportionately amongst all shareholders (including the investor). Hence, the investor receives 33 percent or INR 8 million approximately.

The total amount received by the investor is INR (5 + 8) million = INR 13 million.
Therefore, even though the valuation of the startup has doubled, the VC’s gain is much higher - he has made a return of 2.6 times his investment of INR 5 million (13/5 is 2.6).

A company can issue different classes of shares to investors (these are different classes of preference shares), to ensure that investors can claim preference to the founders (who hold equity shares) when they exit. 

Negotiation points for an entrepreneur or his advisor

An entrepreneur (or his advisor) should carefully go through the investment agreement to see which events qualify as ‘liquidation events’ – ideally the definition should be narrowed down to include only winding-up or other bankruptcy-related events, especially if the clause requires payment of a huge IRR or a multiple of the investment amount. A profitable exit should be excluded from the list of liquidation events. Merger, consolidation or change of control or sale of assets, or a profitable exit opportunity  need not trigger such clauses as the affirmative consent of investors will be required to take such action in any case (see the discussion under ‘Affirmative Voting Rights/ Reserved Matters below’) – an investor will hence have the opportunity to veto such an action, so the liquidation preference need not be triggered.

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