What is 'Liquidation Preference'

Liquidation preference determines the payout order in case of a corporate liquidation. More specifically, liquidation preference is frequently used in venture capital contracts to specify which investors get paid first and how much they get paid in the event of a liquidation event, such as the sale of the company.

BREAKING DOWN 'Liquidation Preference'

Liquidation preference, in its broadest sense, determines who gets how much when a company is liquidated, sold or goes bankrupt. To arrive at a determination, the company's liquidator must analyze the company's secured and unsecured loan agreements as well as the definition of the share capital (both preferred and common stock) in the company's articles of association. In so doing, the liquidator ranks all creditors and shareholders and distribute funds accordingly.

Liquidation Preference and Venture Capital Investments

The use of specific liquidation preference dispositions is popular when venture capital firms invest in startup companies. The investors often make it a condition for their investment that they receive liquidation preference over other shareholders. This protects venture capitalists from losing money by making sure they get their initial investments back before other parties.

In these cases, there does not need to be an actual liquidation or bankruptcy of a company. In venture capital contracts, a sale of the company is often deemed to be a liquidation event. As such, if the company is sold at a profit, liquidation preference can also help venture capitalists be first in line to claim part of the profits. Venture capitalists are usually repaid before holders of common stock and before the company's original owners and employees. In many cases, the venture capital firm also has a participation as a common shareholder.

For example, assume a venture capital company invests $1 million in a startup in exchange for 50% of the common stock and $500,000 of preferred stock with liquidation preference. Assume also that the founders of the company invest $500,000 for the other 50% of the common stock. If the company is then sold for $3 million, the venture capital investors receive $2 million, being their preferred $1M and 50% of the remainder, while the founders receive $1 million. Conversely, if the company sells for $1 million, the venture capital firm receives $1 million and the founders receive nothing.

Other Practical Examples of Liquidation Preference

More generally, liquidation preference can also refer to the repayment of creditors (such as bondholders) before shareholders if a company goes bankrupt. In such a case, the liquidator sells its assets, then uses that money to repay senior creditors first, then junior creditors, then shareholders. In the same way, creditors holding liens on specific assets, such as a mortgage on a building, have liquidation preference over other creditors in terms of the proceeds of sale from the building.

RELATED TERMS
  1. Liquidate

    Liquidate means to convert assets into cash or cash equivalents ...
  2. Participating Preferred Stock

    A type of preferred stock that gives the holder the right to ...
  3. Liquidating Dividend

    A liquidating dividend is a type of payment that a corporation ...
  4. Preferred Stock

    A class of ownership that has a higher claim on assets and earnings ...
  5. Liquidity Preference Theory

    The idea that investors demand a premium for securities with ...
  6. Flight To Liquidity

    A situation where investors attempt to liquidate positions in ...
Related Articles
  1. Investing

    What You Should Know About Preferred Stocks and Interest Rates

    These are the pros and cons of preferred stocks in a rising interest rate environment.
  2. Investing

    Explaining the Liquidity Preference Theory

    According to the liquidity preference theory, investors demand interest in return for sacrificing their liquidity.
  3. Financial Advisor

    Small Cap Investing: How to Think About Illiquidity

    Do your homework, have a long term view, exercise patience, you'll find that investing in small market capitalization stocks is no riskier than investing in large stocks
  4. Investing

    Preferred stocks versus bonds: How to choose

    What is the difference between corporate bonds and preferred stock? A list of pros and cons for each investment.
  5. Small Business

    Who are Venture Capitalists?

    Venture capital investment firms can provide the seed money for high-risk, start-up companies. People called venture capitalists run these firms, and make the investment decisions.
  6. Managing Wealth

    The Different Between Preferred and Common Stock

    Preferred and common stocks are different in two key ways.
  7. Investing

    How Social Venture Capital Is Changing the World

    Learn what social venture capital is and the ways in which it differs from traditional venture capital. Identify two leading social venture capital firms.
  8. Managing Wealth

    Know Your Shareholder Rights

    Common-stock owners have numerous privileges and should be vigilant in monitoring a company.
RELATED FAQS
  1. What is liquidity risk?

    Learn how to distinguish between the two broad types of financial liquidity risk: funding liquidity risk and market liquidity ... Read Answer >>
  2. What is the difference between compulsory and voluntary liquidation?

    Learn about the primary differences between voluntary liquidation and compulsory liquidation, two ways of selling off company ... Read Answer >>
  3. What affects an asset's liquidity?

    Learn about what affects an asset's liquidity, including examples of liquid and fixed assets, and how a company's liquidity ... Read Answer >>
  4. Is it important for a company always to have a high liquidity ratio?

    Understand the significance of the liquidity ratio and how it is used in conjunction with other measures to arrive at an ... Read Answer >>
Hot Definitions
  1. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  2. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  3. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  4. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  5. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  6. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
Trading Center