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.