Liquidation Preference: Everything You Need to Know
Liquidation preference determines the payout process or the distribution of stocks if the company pays dividends, enters into a merger, or liquidates.4 min read
What is Liquidation Preference?
Liquidation preference determines the payout process or the distribution of stocks if the company pays dividends, enters into a merger, or liquidates the company. Liquidation preference means the company's investors or the preferred stockholders receive their investment back first in case the company liquidates.
Liquidation preference determines who gets first and how much when the company is liquidated, sold, or declares bankruptcy. Liquidation preference is associated with the preferred convertible stock. It explains how the proceeds are divided and shared.
For example, a holder of preferred stock has a liquidation preference equal to $30 million and the company is sold. Then the holder will get the first $30 million before the common stockholders receive any amounts.
When the company liquidates, liquidation preferences are one of the special rights of investors. The owner of a preferred stock gets a guaranteed amount of money from the sale. The investors receive a guaranteed amount of 1X of their investment, depending on the negotiation between the investor and the company owner.
Sometimes the multiplier goes higher as part of the negotiation. This is called the multiple liquidation preferences (e.g., 2X multiple, 3X multiple, etc). This means an investor will get double or triple of the amount invested.
Why Is Liquidation Preference Important
For investors that provide capital for companies, whether startup or existing, liquidation preference is an important tool. It offers security on the risk investors make in giving a big amount to finance a company or business. It's the investors' ticket in claiming what they have invested. This is in case the company or business declares bankruptcy.
Liquidation preference also provides companies or businesses an ease on prioritizing who gets paid first and how much.
Reasons to Consider Not Using Liquidation Preference
- Security of investments is at risk for investors if they agreed to provide capital.
- For companies, no investors will provide capital for the business.
- If the business bankrupts or liquidates, founders or business owners will have difficulty in who gets first and how much.
Reasons to Consider Using Liquidation Preference
- Investors will consider providing capital for business or companies because of the security it provides.
- Protection for investors or capitalists from losing money. It ensures they get their initial investments back before other parties.
- Companies can easily close investor deals and can boost business growth.
For example, an investor or venture capital company invests $1 million in a startup company. This is in exchange for 50 percent of the common stock and a $500,000 for the preferred stock with a liquidation preference of 1x. The owner or founder also invests $500,000 for the other 50 percent of the common stock. This equals a total of $2 million capital investment.
If the company declares bankruptcy and sells the company for $3 million, the venture capitalist will get $2 million out of the $1 million common stock and the $500,000 preferred stock. The company's owner will receive $1 million out of the $500,000 investment.
Another example shows the advantage for the capitalist or investor with the liquidation preference. A capitalist invests $1 million preferred stock with a liquidation preference of 1X. The owner provides a $500,000 common stock with a total investment of $1.5 million.
Due to losses, the company was forced to declare bankruptcy and sold the company for only $1 million. The capitalist is ensured of his or her $1 million investment. However, the owner will get nothing from the proceeds of the sale.
Frequently Asked Questions
- What is a common stock?
A common stock is the basic form of equity in the company. Usually, the company's founders or owners, as well as its employees, hold common stocks.
- What is a preferred stock?
A preferred stock has more interest in the company. It can offer aspects such as dividends or voting rights. Typically, venture capitalists and investors in the company hold preferred stocks.
The liquidation preference is usually a preferred stock.
- What are the types of preferred stock?
There are three types of preferred stock:
- Nonparticipating or Straight Preferred Stock. This particular liquidation preference is favorable for business owners or companies. In cases where companies fall into liquidation, the holder of preferred stock will get his or her initial investment. However, the owner will not share in the liquidation proceeds based on the percentage with the common stocks.
- Fully Participating or Double-dip Preferred Stock. This liquidation preference favors the investor. Similar to the nonparticipating or straight preferred, the investor will receive liquidation proceeds based on a percentage of the common stocks after receiving the initial investment.
- Capped or Partially Participating Preferred Stock. This type of liquidation preference is often viewed as an intermediate approach. But their aggregate return is capped. Once the investors received their capped amount, they can no longer share in the remaining proceeds with the other common stockholders.
- What is the advantage of liquidation preference?
The liquidation preference is important in providing security for the risk that investors make in giving a large amount of money to finance a company or business. It ensures they have the first rights to gain back their investments, should the company liquidate.
- Is a 1X liquidation preference unfair?
No, it isn't unfair. For the people who bring the capital to a company, a 1X liquidation preference is a fair protection for their investment. It is their collateral for the risk they take in investing in a company. But it is something that employees should know about and follow. Otherwise, it could lead to a disaster in the liquidation process.
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