A liquidation preference is an essential contract clause that outlines the payout order during corporate liquidation. This ensures that preferred stockholders or investors are compensated first in the event the company is liquidated, sold, or goes bankrupt. The aim is to clarify the payouts and their order, benefiting investors in times of company dissolution.
Key Takeaways
- Payout Hierarchy: Determines who gets paid first and how much during liquidation.
- Investor Protection: Investors or preferred shareholders get repaid before holders of common stock and debtholders.
- Common in Ventures: Frequently used in venture capital contracts to protect investment.
Delving Into Liquidation Preference
Liquidation preference in a broad sense ensures clarity on financial distribution when a company faces dissolution. By analyzing secured and unsecured loan agreements alongside the defined share capital—both preferred and common stock—the liquidator can effectively rank creditors and shareholders and fairly distribute available funds. This precedence secures the repayment rights of certain stakeholders over others.
How Liquidation Preferences Function
Particularly prevalent in venture capital, liquidation preference provides a safety net for investors. Venture capitalists often demand a liquidation preference, making certain they recover their initial investments before other shareholders. This practice is not contingent upon actual insolvency or liquidation but includes sales of company proceeds as liquidation events, allowing investors to recover funding or share profits favorably. Consequently, investors, frequently possessing some common shares, secure initial repayment rights.
Practical Examples of Liquidation Preference
Example 1: High-Value Sale
Imagine a venture capital firm invests $1 million in a startup for 50% of the common stock and $500,000 of preferred stock with liquidation preference. The company’s founders contribute $500,000, owning the remaining 50% of common stock. Upon selling the company for $3 million, venture investors receive $2 million ($1M preference plus 50% share of balance), while founders receive $1 million.
Example 2: Lower Sale Value
If the company sells for only $1 million, venture investors receive the entirety, recouping their $1 million before founders receive anything.
Bankruptcy Scenario
Liquidation preference also ensures creditor repayment during bankruptcy. The liquidator sells assets, paying senior then junior creditors prior to shareholders. Creditors with liens, such as mortgage holders, have priority concerning asset-specific sales proceeds.
Related Terms: venture capital, preferred stock, investor rights, bankruptcy, investment contract.
