Liquidation Preference – Definition

Cite this article as:"Liquidation Preference – Definition," in The Business Professor, updated December 3, 2019, last accessed October 26, 2020, https://thebusinessprofessor.com/lesson/liquidation-preference-definition/.

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Liquidation Preference Definition

The liquidation preference provides a basis for the collection of claims and dividends in the event of a corporation or organization liquidating. This preference stipulates the order in which payout will be done as well as investors or shareholders who get their money (claims and dividends) first if a company is sold or liquidated.

The liquidation preference is a clause that can be found in contracts that states that preferred shareholders and investors are entitled to their investment first in the vent of corporate liquidation.  This important term is mostly overlooked in many contracts but it is often used by investors in venture capital contracts.

A Little More on What is a Liquidation Preference

Primarily, the liquidation preference contains which investors get their money first is a company is to be liquidated (sold) and how much they will get. This preference is a payout order that highlights the position of each investor on the queue in the event of payback if a company liquidates.

As an investor or stockholder in a company, liquidation preference is an important part of the deal or contract that you must not overlook. This clause states the order or payout of a company goes bankrupt or is liquidated. In many cases, the payout order is bot clearly stated in the liquidation preference and the liquidator has the responsibility of ranking the shareholders and distribute money appropriately.

How Liquidation Preferences Work

The liquidation preference is a mandatory term that must be contained in venture capital contracts, venture capital firms that invest in emerging companies also pay attention to this clause to determine the venture capitalists that will receive payment first in the event of corporate liquidation. In many cases, investors give emerging companies a condition on the payout order before investing in them, the payout condition must be favorable and guarantee that the investors will not lose their money in the event of the company being sold or liquidating.

Oftentimes, in liquidation preference, venture capitalists are top on the list of investors that will be paid first if a company liquidates.

Liquidation Preference Examples

Usually, venture capitalists of venture capital companies are paid fits before common stockholders and employees of a company in the event of a liquidation. Below is an example of liquidation preference;

Company XYZ is a startup company and requires funding to harness growth, a venture capital company invests $2 million into the company and has 60% of the company’s common stock and preferred stock which amounts to $750. The owners of the company and other investors who invest in the company ar also entitled to a payout. However, in the event of liquidation, the venture capital company will receive payout first before others are considered, being the highest investor.

Key Takeaways

  • The liquidation preference is a clause in a contract that states the investors that will receive payment first in the event of corporate liquidation in a company. The amount the investors will receive is also stated in the liquidation preference.
  • According to liquidation preference, venture capitalists preferred shareholders or investors receive payment first before holders of common stock of a company.
  • The repayment order or bondholders or creditors when a company goes bankrupt is also described as a liquidation preference.
  • When used for creditors, the liquidation preference mandates that senior debts are settled first before junior creditors receive payment.

References for “Liquidation Preference”

https://www.upcounsel.com/liquidation-preference

https://www.investopedia.com › Small Business › Entrepreneurship

https://www.seedinvest.com/blog/startup-investing/liquidation-preferences

https://en.wikipedia.org/wiki/Liquidation_preference

https://www.upcounsel.com/liquidation-preference

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