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Exit conditions and liquidation preference under shareholder’s agreement

What does an Exit Condition mean?

The investor may impose certain mechanism in the shareholders’ agreement through which the investor will get certain assurances for exiting the company in the future. These preferences enable an assured exit for the investor. As a result, the Founder is under an obligation to provide a guaranteed exit to the investor. 

How are these conditions imposed?

Under these terms, the investor may require the Founder to ensure an exit event happens within a specified period of time ( 5 to 10 years). 

The exit event may have effected in the following order of preference: a)IPO

The Founder shall be under an obligation to ensure that the company offers its shares to the public through an initial public offer on a recognised stock exchange in India.

b) Sale to third-party

If IPO does not occur, the Founder shall be under an obligation to find a third-party seller to whom the investor can sell his shares.  Usually such secondary sale happen at the fair market value of the shares.

c) Company or Founder buyback

Where the secondary sale fails, the investor may put obligation on the company or the Founder to mandatorily buy the shares held by the investors.

What does liquidation preference mean?

Liquidation preference clause usually provides that in the case of a liquidation event, the investor will be entitled to receive the investment amount and other reserves in priority to other shareholders. 

What is a Liquidation Event?

Before understanding liquidation preference, it is important to understand what a liquidation event refers to.

While liquidation event can be freely defined between the parties, typically, the following situations could result in a liquidation event: •Bankruptcy or liquidation of the company •Sale of substantial assets of the company •Any restructuring of the company, or change of control etc, as a result of which the current shareholders of the company become minority shareholders. 

However, where the restructuring or sale happens with the prior consent, such events may be excluded from liquidation events.

What happens when Liquidation Event is triggered?

Upon occurrence of any of the events above, it is agreed through the shareholders’ agreement that the investor shares will have priority over the Founder shares and whatever is distributed from the company will be first assigned to the investors.

This post is part of our Founder’s handbook – “Negotiating Shareholder’s Agreement”, a comprehensive handbook for founders to negotiate shareholder’s agreement. Click here to download the complete handbook.

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