What is liquidation preference?
The liquidation preference is a clause in a contract which dictates the payment order in the event of a company liquidation. Typically, investors or preferred shareholders in the business get their money back first, before other types of shareholders or creditors, in the event that the company needs to be wound up.
The reference to liquidation preference is frequently used in venture capital contracts to clarify which investors are paid in what order and to specify how much they are paid in the event of liquidation, such as the sale of the company.
[Important: The liquidation preference determines who gets their money first when a company is sold, and how much money they are entitled to get.]
Understanding the liquidation preference
Liquidation preference, in its broadest sense, determines who gets how much when a business is wound up, sold or goes bankrupt. To reach this conclusion, the company’s liquidator must analyze the company’s secured and unsecured loan agreements, as well as the definition of share capital (both privileged and ordinary) in the company’s articles of association. As a result of this process, the liquidator is then able to classify all creditors and shareholders and distribute the funds accordingly.
How liquidation preferences work
The use of specific liquidation preference provisions is popular when venture capital firms invest in start-up businesses. Investors often make their investment a condition of liquidation preference over other shareholders. This protects venture capitalists from losing money by ensuring that they recover their initial investments before the other parties.
In these cases, there is no need for the liquidation or actual bankruptcy of a business. In venture capital contracts, the sale of the company is often viewed as a liquidation event. As such, if the company is sold at a profit, the liquidation preference can also help venture capitalists to be the first to claim part of the profits. Venture capitalists are generally repaid to common shareholders and to the original owners and employees of the business. In many cases, the venture capital firm is also an ordinary shareholder.
Examples of liquidation preferences
For example, suppose 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 preference to liquidation. Suppose also that the founders of the company invest $ 500,000 for the remaining 50% of the common shares. If the company is then sold for $ 3 million, venture capitalists receive $ 2 million, their preference being $ 1 million and 50% of the rest, while the founders receive $ 1 million.
Conversely, if the company sells $ 1 million, the venture capitalist receives $ 1 million and the founders receive nothing.
More generally, the preference for liquidation may also refer to the reimbursement of creditors (such as bondholders) before shareholders in the event of the bankruptcy of a company. In such a case, the liquidator sells his assets, then uses this money to repay first the senior creditors, then the junior creditors, then the shareholders. Likewise, creditors holding liens on specific assets, such as a mortgage on an immovable, have a preference for liquidation over other creditors in terms of proceeds from the sale of the immovable.
Key points to remember
- The windup preference determines who gets paid first and how much they get paid when a business needs to be wound up, such as selling the business.
- Investors or preferred shareholders are generally redeemed first, before holders of common shares.
- Liquidation preference is frequently used in venture capital contracts to specify which investors are reimbursed and how much they get in the event of liquidation.