Liquidation Preference
A liquidation preference is a clause in a contract that dictates the payout order in case of a corporate liquidation. Typically, the company's investors or preferred stockholders get their money back first, ahead of other kinds of stockholders or debtholders, in the event that the company must be liquidated. Liquidation preferences are frequently used in venture capital contracts, "
Liquidation Preference
Definition
Liquidation preference refers to the contractual right that determines the order of payment in the event of a company's liquidation. Typically, in the event of liquidation, investors or preferred shareholders will recover their funds before other types of shareholders or creditors. This arrangement is often used in venture capital agreements.
Origin
The concept of liquidation preference originated from early corporate and bankruptcy laws, aiming to protect investors' interests, especially in high-risk investment environments. As the venture capital industry developed, liquidation preference became a standard clause in venture capital agreements to ensure that investors could recover part or all of their investment in the event of a company's failure.
Categories and Characteristics
Liquidation preference mainly falls into the following categories:
- Participating Liquidation Preference: In the event of liquidation, preferred shareholders can not only recover their investment amount first but also share the remaining assets with common shareholders.
- Non-Participating Liquidation Preference: Preferred shareholders can only recover their investment amount first and cannot participate in the distribution of remaining assets.
- Multiple Liquidation Preference: Preferred shareholders can recover multiple times their investment amount in the event of liquidation, usually 1.5x or 2x.
Specific Cases
Case 1: A startup company A received investment from venture capital firm B, with a contract stipulating that B has a 1.5x non-participating liquidation preference. Years later, company A needs to liquidate due to poor performance. At liquidation, company A's total assets amount to $1 million, and B's investment amount is $500,000. According to the contract, B will recover $750,000 (500k x 1.5) first, and the remaining $250,000 will be distributed to other shareholders.
Case 2: A tech company C received investments from multiple investors, among which investor D has a participating liquidation preference. At liquidation, company C's total assets amount to $2 million. D's investment amount is $1 million. According to the contract, D will first recover $1 million and then share the remaining $1 million with other shareholders.
Common Questions
Q1: Does liquidation preference affect the interests of common shareholders?
A1: Yes, liquidation preference prioritizes payment to specific investors or shareholders, which may reduce the assets available for distribution to common shareholders during liquidation.
Q2: Is liquidation preference only applicable during company liquidation?
A2: Typically, yes. Liquidation preference mainly takes effect during company liquidation or sale, but specific terms may vary and should be determined based on the contract.
