What Is a Liquidation Preference?
Liquidation preference is a term used in contracts to specify the hierarchy of payout to the shareholders when the company is liquidated, sold, or goes bankrupt. Essentially, it ensures that certain investors receive their investment back before other shareholders.
Liquidation Preference Definition
It refers to the order in which shareholders are paid if the company is sold or liquidated. Preferred shareholders typically have liquidation preferences over common shareholders, meaning they will be paid first. The exact preferences depend on the terms agreed upon by the shareholders and company.
Preference is related to the series of shares
Liquidation preferences are often linked to different series of preferred shares, such as Series A, Series B, etc. Investors in earlier rounds may have different preferences compared to later rounds, and this is often negotiated during each funding stage.
For example, Preferred Series B shares tend to be senior to Preferred Series A shares, which are senior to common shares. It is common to find language such as:
In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).
The typical preference is one times (1x) the original purchase price. However, in challenging economic times when investors may be scarce, this preference could be higher.
Three types of participation features
Participation refers to the way preferred shareholders can participate in the distribution of remaining funds after they have received their initial liquidation preference. There are three main types:
Non-participating preferred stock
With non-participating preferred stock, shareholders receive only their liquidation preference and nothing more. Once they receive this amount, any remaining funds are distributed among the common shareholders.
Fully participating stock
Fully participating shareholders receive their liquidation preference and then also share in any remaining funds, often on a pro-rata basis with common shareholders. This can result in a higher payout for preferred shareholders.
Capped participation is a hybrid between the two other types. Shareholders receive their liquidation preference, then participate in remaining distributions, but only up to a certain cap. Once that cap is reached, the rest goes to the common shareholders.
Liquidation preferences can be a complex but essential part of investment agreements. They provide protection to investors and structure to the distribution of assets in the event of a liquidation event. Always consult with legal professionals when dealing with these terms in an investment contract.