What Is a Liquidation Preference?
Let me explain what a liquidation preference is—it's a contractual right that gives preferred stockholders priority over others when it comes to getting paid during a company's liquidation. You should know that this preference prioritizes preferred investors if a company goes bankrupt or shuts down, ensuring they get their money back before anyone else, and it also sets how much they receive. These preferences reduce risk for investors and function like an insurance policy. You'll find them commonly in venture capital contracts, hybrid debt instruments, promissory notes, and other structured private capital deals to make clear who gets paid and in what order during liquidation.
Key Takeaways
Here's what you need to grasp: liquidation preferences decide who gets paid first and how much when a company must be liquidated. Investors or preferred shareholders typically get repaid ahead of common stock holders and debt holders. And remember, this is a frequent feature in venture capital contracts.
Understanding Liquidation Preference
In the broadest terms, liquidation preference determines who gets how much when a company is liquidated, sold, or goes bankrupt. To figure this out, the company's liquidator has to review secured and unsecured loan agreements, plus the definitions of share capital—both preferred and common stock—in the company's articles of association. From there, the liquidator ranks all creditors and shareholders and distributes funds based on that order.
You should note that liquidation preference sets who gets their money first in a company sale and how much they're entitled to. This is especially popular in venture capital investments in startups, where investors insist on it as a condition to protect against losses by getting their initial investments back before others. In these scenarios, it doesn't even require actual liquidation or bankruptcy—venture capital contracts often treat a company sale as a liquidation event. So if the company sells at a profit, venture capitalists get first dibs on the profits, ahead of common stock holders, original owners, and employees. Often, the venture capital firm holds common shares too.
Liquidation Preference Example
Consider this example to see it in action: suppose a venture capital company invests $1 million in a startup for 50% of the common stock and $500,000 of preferred stock with liquidation preference. The founders invest $500,000 for the other 50% of common stock. If the company sells for $3 million, the venture capitalists get $2 million—that's their preferred $1 million plus 50% of the remainder—while founders get $1 million. But if it sells for $1 million, the venture capitalists take the full $1 million, and founders get nothing.
More broadly, liquidation preference also covers repaying creditors like bondholders before shareholders in bankruptcy. The liquidator sells assets and pays senior creditors first, then junior ones, then shareholders. Creditors with liens on specific assets, like a building mortgage, have preference over others for proceeds from that asset.
How Does Liquidation Preference Work?
Liquidation preference works by establishing who gets what amount when a company is liquidated, sold, or bankrupt. The liquidator examines the business's secured and unsecured loans, along with share capital definitions in the articles of association.
How Does Liquidation Preference Apply to Venture Capital?
In venture capital, investors often require liquidation preference over other shareholders as an investment condition. This guarantees they recover their initial investments before anyone else.
How Does Liquidation Preference Apply to Startup Companies?
For startups, liquidation preference doesn't need an actual liquidation or bankruptcy to kick in. Venture contracts often count a company sale as a liquidation event, allowing venture capitalists to claim profits first if sold at a gain.
The Bottom Line
To wrap this up, liquidation preference is a clause that decides who gets paid first and how much in events like company liquidation or sale. Venture capitalists, as preferred shareholders, usually get repaid ahead of common stock holders and debt holders.
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