Liquidation Preference

What Is a Liquidation Preference?

A liquidation preference is a clause in a contract that directs the payout order in case of a corporate liquidation. Commonly, the company's investors or preferred stockholders get their money back first, ahead of different sorts of stockholders or debtholders, if the company must be liquidated. Liquidation preferences are much of the time utilized in venture capital contracts, hybrid debt instruments, promissory notes and other structured private capital transactions, to explain what investors get compensated and in which order during a liquidation event, for example, the sale of the company."

Figuring out Liquidation Preference

Liquidation preference, in its broadest sense, determines who gets how much when a company is liquidated, sold, or fails. To arrive at this resolution, the company's liquidator must examine the company's secured and unsecured advance arrangements, as well as the definition of the share capital (both preferred and common stock) in the company's articles of association. Because of this interaction, the liquidator is then able to rank all creditors and shareholders and disseminate funds in like manner.

The liquidation preference determines who gets their money first when a company is sold, and how much money they are qualified for get.

How Liquidation Preferences Work

The utilization of specific liquidation preference manners is famous when venture capital firms invest in startup organizations. The investors frequently cause it a condition for their investment that they to receive liquidation preference over different shareholders. This safeguards venture capitalists from losing money by ensuring they get their initial investments back before different parties.

In these cases, there needn't bother with to be a real liquidation or bankruptcy of a company. In venture capital contracts, a sale of the company is frequently considered to be a liquidation event. Thusly, on the off chance that the company is sold at a profit, liquidation preference can likewise assist with wandering capitalists be preferred choice to claim part of the profits. Venture capitalists are generally repaid before holders of common stock and before the company's original owners and employees. Generally speaking, the venture capital firm is likewise a common shareholder.

Liquidation Preference Examples

For instance, expect a venture capital company invests $1 million in a startup in exchange for half of the common stock and $500,000 of preferred stock with liquidation preference. Expect additionally that the founders of the company invest $500,000 for the other half of the common stock. In the event that the company is, sold for $3 million, the venture capital investors receive $2 million, being their preferred $1M and half of the remainder, while the founders receive $1 million.

On the other hand, assuming the company sells for $1 million, the venture capital firm receives $1 million and the founders don't receive anything.

All the more generally, liquidation preference can likewise allude to the repayment of creditors (like bondholders) before shareholders in the event that a company fails. In such a case, the liquidator sells its assets, then utilizes that money to repay senior creditors first, then junior creditors, then shareholders. Similarly, creditors holding liens on specific assets, like a mortgage on a building, have a liquidation preference over different creditors in terms of the proceeds of sale from the building.

Features

• The liquidation preference is often utilized in venture capital contracts.
• Investors or preferred shareholders are typically paid back first, ahead of holders of common stock and debt.
• The liquidation preference determines who gets compensated first and the amount they get compensated when a company must be liquidated, like the sale of the company.