Definition
Liquidation preference refers to the specific order or hierarchy in which a company’s shareholders are paid in the event of its liquidation. It is often used in venture capital contracts to prioritize the payout of preferred shareholders over common shareholders. The specified order of payment is usually based on the amount of money invested and the type of shares owned.
Phonetic
/ˌlikwɪˈdeɪʃən prɪˈfɛrəns/
Key Takeaways
- Liquidation preference is a key term in investment agreements, providing investors with a guarantee to be paid back their initial investment before other shareholders in case of an event of liquidation (ex. company’s dissolution, bankruptcy, or sale).
- Types of Liquidation Preference: There are mainly two types of liquidation preferences – Non-Participating and Participating. In a non-participating preference, once the investors received their guaranteed amount, the remaining assets get distributed among the common shareholders. On the other hand, in participating preference, after investors receive their liquidation preference, they also participate in the division of the remaining assets.
- Impact of Liquidation Preferences: Liquidation preference serves to protect investors, especially in high-risk investments. It can significantly affect the payout to other shareholders and the founders. Therefore, terms of these preferences should be carefully negotiated during investment agreements.
Importance
The business/finance term “Liquidation Preference” is vitally important as it represents the order in which the proceeds will be divided among shareholders in the event of a liquidation, sale, or dissolution of a company. It is especially significant to preferred shareholders, particularly venture capital investors, as it can provide a form of downside protection, assuring they get paid before others if the company is sold or dissolved. This term often negotiates in investment agreements to secure that certain stakeholders, often investors, have priority to recoup their initial investment, sometimes augmented by a set percentage. This can substantially alter the distribution of profits, particularly if a company sells for less than anticipated.
Explanation
The purpose of the finance/business term “liquidation preference” is to provide a certain level of protection for investors, particularly in venture capital or private equity settings, where the risk of failure or loss can be significantly high. It sets a specific order of payout during a liquidation event, such as the sale of the company, bankruptcy, or any other situation in which the company’s assets are being sold off. These preferences assure investors that they will receive their investments back before any common shareholders receive money.Liquidation preference is typically used in the negotiation process during investment rounds, and it essentially determines who gets paid first, and how much, once the company’s assets are liquidated. It helps to reduce the financial risks for investors by prioritizing their recoupment and can often be an influential factor for investors deciding to fund a startup or emerging company. Therefore, entrepreneurs need to be aware of the implications liquidation preference could have down the line, particularly because a high liquidation preference could mean they, as common shareholders, receive a lot less of the proceeds in the event of a sale or liquidation.
Examples
1. Venture Capital Investment: Let’s say a venture capital firm invests $5 million in a startup for a 25% stake, with a 1X liquidation preference. This means if the startup gets sold, the venture capital firm would first get $5 million (1X of their initial investment) from the proceeds before the rest is distributed among shareholders. For instance, if the startup is sold for $20 million, the investor would get $5 million off the bat. The remaining $15 million would then be divided among all shareholders proportionally.2. Mergers and Acquisitions: Consider a company named ABC Corp., with two categories of stock owners: Common stockholders and Preferred stockholders. The preferred stockholders have a 2X liquidation preference. ABC Corp. is purchased by XYZ Inc. for $30 million. If the preferred stockholders had initially invested $10 million, then they would receive $20 million (2X their investment) before any distribution is made to the common shareholders.3. Bankruptcy: When a company declares bankruptcy and must liquidate its assets, a particular order is followed for disbursing the proceeds. Creditors with liquidation preference, such as bondowners or preferred shareholders, have a right to be paid before other types of creditors. The bankruptcy of the retail giant Toys ‘R’ Us is an example, where secured lenders were entitled to get their money first – they were top of the queue in the liquidation preference. Unsecured creditors, like suppliers, were further down the line.
Frequently Asked Questions(FAQ)
What is Liquidation Preference?
Liquidation Preference is a clause in a contract that determines the payout order in case of a corporate liquidation. Often used in venture capital contracts, it gives certain investors the right to receive their investment back before other shareholders in the event of a sale or liquidation of the company.
What is the main purpose of Liquidation Preference?
The main purpose of a liquidation preference is to protect the interests of preferred shareholders, typically venture capitalists or other investors, in the event of a company’s liquidation or sale.
How does Liquidation Preference work in case of company dissolution or exit?
In case of a company’s liquidation or exit, investors with liquidation preferences get paid first, typically before common shareholders. The specific amount they receive is dictated by the terms of their liquidation preference, which can be either a multiple of their original investment or a pre-determined fixed amount.
Are there different types of Liquidation Preferences?
Yes. There are two main types, Non-participating and Participating. Non-participating means investors get either their initial investment or a fraction of the company proportional to their ownership, but not both. Participating means investors first get their initial investment back, then also get a fraction of remaining assets proportional to their ownership.
What is a 1x Liquidation Preference?
A 1x liquidation preference means that an investor is entitled to receive an amount equal to their investment before any proceeds from a sale or liquidation are distributed to other shareholders. For example, if an investor has invested $1 million and has a 1x liquidation preference, they would receive the first $1 million from any liquidation.
Can Liquidation Preference be negotiated?
Yes, liquidation preferences can be negotiated between the company and its investors during the fundraising process. The terms of a liquidation preference can significantly impact the distribution of a company’s assets, so companies and investors often negotiate these terms carefully.
Is Liquidation Preference the same for all shareholders?
No, not all shareholders have a liquidation preference. This clause is typically only part of convertible preferred stock, often owned by venture capitalists or angel investors. Common shareholders, including employees owning stock options, usually do not have a liquidation preference.
Related Finance Terms
- Preferred Stock: This is a category of stock that gives holders certain rights over common stockholders. Liquidation preference is typically one of these rights.
- Debt Financing: This term is related to liquidation preference as it refers to raising capital by borrowing, either from a bank or by issuing bonds. In case of liquidation, creditors are given preference over equity holders.
- Redemption Rights: This term refers to the right of a preferred stockholder to demand that the company repurchase their stock. It is related to liquidation preference as it deals with the prioritization of who gets their investment back first.
- Venture Capital: This term refers to the financing provided to start-up companies by investors. It is closely related to liquidation preference, as liquidation preference is commonly used in venture capital deals.
- Participation Rights: This is a term referring to the rights of preferred stockholders to participate in the distribution of any remaining assets, after they’ve received their liquidation preference, along with common stockholders.
