What is Liquidation Preference?
Liquidation preference determines the order in which a bankrupt firm’s liquidated assets are paid out to claimants of the firm. It is determined based on the clauses in outstanding agreements and contracts by a liquidator.
Further, the liquidation preference can also influence the value of financial securities as it can alter the risk of a security. If a security is higher up on the liquidation preference, there is less downside to the security. Thus, holding all else equal, the price of the security will be greater. This is in line with the principle of risk and return.
Though the liquidation preference can play an active part in the value of securities, it should be noted that it is only acted upon when a company goes bankrupt and must liquidate. Liquidation preference typically holds that secured creditors get paid first, followed by unsecured creditors and then shareholders.
However, the liquidation can, and usually is, far more complicated; the above is simply a general rule of the liquidation preference. Furthermore, it also applies when a business is sold.
Liquidation Preference and Shareholders
When a firm is liquidated, taxes and creditors are typically paid first, followed by the firm’s shareholders. Shareholders are generally split between preferred and common shareholders. Preferred shareholders come before common shareholders in the liquidation preference order, and are paid out first before common shareholders can get anything.
In addition, if there is anything leftover from when the preferred shareholders are paid through their liquidation preference covenant, the leftover is shared between common shareholders and preferred shareholders based on their respective ownership in the company. With start-ups, preferred shares are typically given to early investors in the start-up.
Liquidation Preference and Venture Capitalists
Liquidation preference is very popular when venture capital firms invest in start-up firms. Venture capital firms face significant risk when investing in start-up firms. As stated by the U.S. Bureau of Labor, 20% of start-ups go bankrupt within the first year of operations. To hedge this risk, venture capital firms include liquidation preference clauses in their contracts.
Also, the clauses can be quite lucrative. Venture capital firms can include a 2x liquidation preference clause, which is where the venture capital firm is entitled to two times its original investment in the start-up.
For example, if a venture capitalist firm invested $75M in a start-up with a 2x liquidation preference clause and the start-up was later sold for $200M, it would mean the venture capital firm would be entitled to $150M purely from the liquidation preference clause.
As an example, assume that a venture capital firm invests $15M into a start-up for 40% of the start-up’s common shares and $5M of preferred shares with a 2x liquidation preference. Further, assume that the start-up does not owe money to creditors. Additionally, its founders invested $15M for the other 60% of the common shares.
The company was later sold for $100M. Thus, according to the preferred share liquidation preference that the venture capital firm holds, it would receive $10M (2x $5M). The remaining $90M would be split between the common shareholders of the start-up based on their respective ownership of the company.
The start-up’s founders own 60% of the common shares and would receive $54M. The venture capital firm holds the other 40% of common shares and would receive $36M.
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