Definition
Liquidation preference is a term used in venture capital contracts to specify which investors get paid first and how much they receive in the event of a liquidation event, such as the sale of the company, initial public offering (IPO) or bankruptcy. It often provides protection to preferred shareholders by ensuring they get their investment back before other parties. The specific terms of the preference, like the amount and ranking, are set out in the company’s capitalization or cap table.
Key Takeaways
- Liquidation Preference is a term used in venture capital contracts to specify which investors get paid first and how much they get paid in the event of a liquidation or any other capital event like the sale of the company.
- It serves as a protective clause for investors, giving them preference over common shareholders (including employees) to receive the proceeds from an exit. This is crucial in the case where a company is sold at a low amount, as they’ll get to reclaim their investment first.
- Its structure can profoundly affect how much money common shareholders receive from a sale. Common structures are non-participating (investors choose to either get their investment back OR convert to common stock and get their share of the total), and participating (the investor gets their initial investment back AND the same proportion of what’s left as if they had converted to common stock).
Importance
Liquidation Preference is a crucial term in finance, particularly in venture capital and private equity, as it dictates the payout order in case of a company’s liquidation.
Essentially, it ensures that certain investors receive their investment returns before others.
This term is significant for investors, specifically preferred shareholders, because it provides a level of security for their investment.
If a company goes bankrupt or is sold, those with liquidation preference (usually preferred stockholders or debt holders) will receive their share of the company’s assets first, often at a multiple of their original investment, before common stockholders or employees receive anything.
Therefore, it reduces the financial risk and increases the potential profitability for these particular stakeholders.
Explanation
Liquidation preference is primarily intended to protect investors when they invest in a new company. When investors choose to put their money into a startup or a new venture, they are taking a considerable risk as there is always a chance that the company may fail or not yield the expected returns.
To safeguard their investment, liquidation preference is incorporated into their investment agreement, which ensures that in case the company gets sold or liquidated, these investors will get their money back before the remaining proceeds are distributed among other shareholders. The purpose of liquidation preference is to secure the position of the investors in the event of a company’s liquidation or sale.
It acts as a form of insurance, which guarantees that even if things do not pan out as planned, the investors’ initial investment will be returned. However, it’s not just a mechanism to return the investment, but it can also determine the order of payouts.
Depending on the investment terms, some investors may even be entitled to receive multiples of their initial investment before the surplus is distributed to other stakeholders. This serves as a powerful incentive for investors to invest in higher-risk startups.
Examples of Liquidation Preference
Start-up Company Funding: Investors in start-up companies often negotiate a liquidation preference as part of their investment agreement. For instance, if an investor puts $1 million into a company and negotiates a 2x liquidation preference, they are entitled to the first $2 million of any proceeds from an exit event (such as a sale), after paying off any debts. In 2007, Microsoft made an investment in Facebook at a $15 billion valuation. Despite this huge valuation, Microsoft’s investment was relatively safe because they had a liquidation preference which would have ensured they received back their investment prior to any other shareholders.
Bankruptcy or Dissolution of a Company: When Circuit City, a well-known electronics retailer, filed for bankruptcy, it had to sell off all its assets to repay creditors. The liquidation preference determined the order of payout. Secured creditors like banks and bondholders were first in line, followed by unsecured creditors including vendors. Equity holders (investors, employees) were last, and often received nothing, demonstrating the downside of lower (or no) liquidation preference.
Acquisition: When software giant Oracle acquired Sun Microsystems for approximately $
4 billion, shareholders did not receive equal parts of the deal. Shareholders with preferred stocks, which often carry liquidation preferences, were paid out first, before common shareholders. Some of these preferred shareholders were entitled to up to a certain multiple of their original investment due to their liquidation preference clause.
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FAQ for Liquidation Preference
1. What is Liquidation Preference?
Liquidation preference refers to the clause in a contract of an investor which determines the payout order in case of corporate liquidation. In other words, the investors who have preference shares with a liquidation preference clause would be paid first during a liquidation event before common shareholders get paid.
2. What is the purpose of a Liquidation Preference?
The purpose of liquidation preference is to protect the investors in a start-up. It gives the preferential right to get back their initial investment before the proceeds of the liquidation are distributed among the common shareholders.
3. Are there different types of Liquidation Preference?
Yes, there are different types of Liquidation Preferences. Some of the most common ones include non-participating liquidation preference, participating liquidation preference and capped participating liquidation preference, each serving a slightly different purpose.
4. What is a Participating Liquidation Preference?
In a participating liquidation preference, the investor first gets the amount invested back as per the multiple decided, and then also participates in the remaining proceeds, in proportion to his shareholding.
5. What is a Non-Participating liquidation preference?
In a non-participating liquidation preference, the investor gets a choice to either get back the investment as per decided multiple or participate in the liquidation proceeds in proportion to their equity ownership, but not both.
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Related Entrepreneurship Terms
- Preferred Stock
- Participation Rights
- Capital Structure
- Convertible Securities
- Venture Capital Financing
Sources for More Information
- Investopedia: This is a comprehensive source of financial information that has articles explaining various financial terms, including liquidation preference.
- Entrepreneur: This is a site dedicated to business-minded individuals that may contain articles and guides on understanding finance concepts, including liquidation preference.
- Fundera: A site geared towards helping small businesses gather financial insights, which includes potential articles on different finance terms such as liquidation preference.
- Divestopedia: This is a resource for business owners and executives to learn about mergers, acquisitions, and other exit strategies, which may involve understanding terms like liquidation preference.
