What is Liquidation Preference?
408 reads · Last updated: December 5, 2024
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, "
Definition
Liquidation preference is a contractual provision that dictates the order of payment during a company's liquidation. Typically, in the event of a company's liquidation, investors or preferred shareholders are paid back their funds before other types of shareholders or creditors. Liquidation preference is often used in venture capital agreements.
Origin
The concept of liquidation preference originated from the development of corporate and bankruptcy laws, aimed at protecting investors' interests, especially in high-risk investment environments. With the rise of the venture capital industry, liquidation preference became a crucial clause in investment agreements to ensure investors could recover their investments first in case of company failure.
Categories and Features
Liquidation preferences are generally categorized into participating and non-participating types. Participating liquidation preference allows preferred shareholders to recover their initial investment and also participate in the distribution of remaining assets. Non-participating liquidation preference limits recovery to the initial investment. Participating preference is more favorable to investors but may disadvantage common shareholders.
Case Studies
During the 2008 financial crisis, many companies faced liquidation, and preferred shareholders, such as in the case of Lehman Brothers, used liquidation preference to recover part of their investments. Another example is WeWork's failed IPO in 2019, where SoftBank, as a major investor, exercised its liquidation preference to ensure partial recovery of its investment.
Common Issues
Investors often misunderstand the scope of liquidation preference, assuming it guarantees full recovery of investment in all situations. In reality, the recovery amount depends on the remaining assets of the company. Additionally, the distinction between participating and non-participating preferences is often overlooked, affecting investors' decisions.
