Liquidation Preference Definition Examples How It Works

Liquidation Preference Definition

Liquidation preference is a clause that states the order of payment from the realization of assets if the entity loses its corporate status and becomes bankrupt. It protects the invested amount by the preferred shareholders in case the entity goes under the liquidation process, whether voluntary or involuntary.

What is Liquidation?

Liquidation, in layman’s terms, is the end of the company. It also means transferring the company to other hands or selling the business. In liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more, the company needs to cash all its assets, pay off the liabilities, and distribute the funds to various claimants, including investors, with the liquidation preference title. Venture capital investors generally use this clause to protect their investments.

Process of Liquidation Preference

The following process follows for the investors with the liquidation preference clause:

First, it must check whether the investor is a preferred investor or common stockholderCommon StockholderCommon stocks are the number of shares of a company and are found in the balance sheet. It is calculated by subtracting retained earnings from total equity.read more such as an employee or other stakeholders. He will be entitled to receive the receipts as other shareholders share them.Then, we must consider the multiple allotted to their invested capital. Multiple denotes what would receive the investment times if the company exists. Generally, it ranges between 1-3, and If no multiple is attached, the investor would not be able to get its share of proceeds based on liquidation preference.We also need to check whether the preferential investor does have a participating right or not. Participating rights entitles the investor to share the proceeds in addition to its liquidation preference and as a common stakeholder based upon the percentage of his holding. And, if the investor is also a participating right holder, he will receive the additional amount. Otherwise, he will only receive the funds for his liquidation preference.

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Types of Liquidation Preference

Multiple types are floating in the market. We will cover some important ones:

Liquidation preference multiple is one of the most favorite ways investors protect themselves in case of liquidation. It states the amount one would repay in multiple of the capital invested by the investors. For example, someone invested $1 million, and his liquidation preference is 1. Then, if adequate funds generate from liquidating the entity, he will receive his initial investment back, i.e., $1 million.In the case of participating liquidation preference, investors would receive an additional amount from the equity ownership after paying.In straight or non-participating liquidation preference, an investor with a preferred stock with a non-participating preference is eligible for a higher return in the following options. He can either convert his preferred stock into common stock and receive proceeds or only his entitlement from preferred stock.The capped liquidation process is also widely used. Here, the investor and entity get equal benefits. If an investor has this preference, he will be eligible to receive the preference amount and the additional amount from common equity. Still, his earnings would be capped to a limit, as mentioned in the contract.Some liquidation preference does exist based on seniority, too, such as: –When a clause is introduced based on seniority level in the contract, the last tranche of investor preference would consider over the earlier ones in repayments.In the case of pari-passu seniority, the proceeds would be equally distributed to all the investors with this preference in the ratio of their investments if the receipts cannot be paid back in full.One more type of seniority preference is known as hybrid or tiered seniority. Again, the investors are pooled together and paid according to the pari passuPari PassuPari Passu is a standard clause in a financial agreement that ensures equal management and distribution of assets, securities, and debt obligations among creditors.read more principle.

Example of Liquidation Preference

Let us assume a Venture Capital Group has invested $250 million for a 50% share in the business. It has a non-participating liquidation preference in the ratio of, say, 0:1:2:3 of its investment value. Later, the company was acquired for $100/250/500/1,000 million. The venture capitalist would be entitled to the proceeds as follows: –

When a clause is introduced based on seniority level in the contract, the last tranche of investor preference would consider over the earlier ones in repayments.In the case of pari-passu seniority, the proceeds would be equally distributed to all the investors with this preference in the ratio of their investments if the receipts cannot be paid back in full.One more type of seniority preference is known as hybrid or tiered seniority. Again, the investors are pooled together and paid according to the pari passuPari PassuPari Passu is a standard clause in a financial agreement that ensures equal management and distribution of assets, securities, and debt obligations among creditors.read more principle.

In the above example, if the venture capital group is entitled to a share in the proceeds or has a participating share, one will pay the additional share after the liquidation preference. As a result, the Venture Capital Group would receive the ownership proceeds as per the following formula: –

Share of Venture Capital Group = (Total Proceeds – Liquidation Preference) * Share of Venture Capital Group

Refer to the excel sheet for the detailed calculation.

Advantage

This preference acts as insurance for investors. It must liquidate if the company cannot meet its target or fails in its venture. Hence, the investors prefer or guarantee funds; they get their invested amount.

Limitations

The liquidation preference is applicable only when a company goes into liquidation due to bankruptcy, recapitalizationRecapitalizationA recapitalization is a method of restructuring the ratios of various capital-generating modes, such as debt, equity, and preference shares, based on WACC and other company requirements, such as desired control level.read more, or does merger and acquisition, etc. But the investor preference is unsuitable if the company takes out an Initial Public OfferingInitial Public OfferingAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more. In this case, all the preference shareholders generally convert to the common shareholders.

Conclusion

Overall, the investor preference clause helps the investor protect their investments in case of liquidation of the company, where the proceeds are quite scarce. Otherwise, it allows the investor to clock some extra gains when its profits liquidate and are more than sufficient to cover expenses.