Liquidation Preference

Definition

Liquidation preference is a contractual right that gives certain shareholders, typically preferred stockholders, priority over common stockholders in the event of a company's liquidation or acquisition. It determines the order and amount of payouts to shareholders when a company's assets are distributed.

5 Must Know Facts For Your Next Test

1. Liquidation preference gives preferred stockholders the right to be paid out first before common stockholders in the event of a company's liquidation or acquisition.
2. The liquidation preference is typically expressed as a multiple of the original purchase price of the preferred stock, such as 1x or 2x.
3. Preferred stockholders with a higher liquidation preference will receive their full payout before common stockholders receive any distribution.
4. Liquidation preference can play a significant role in negotiations between investors and founders, as it determines the allocation of a company's assets upon a liquidity event.
5. The strength of a liquidation preference clause can impact a company's ability to raise additional funding, as it affects the potential payouts to new and existing investors.

Review Questions

• Explain the purpose of a liquidation preference and how it benefits preferred stockholders.
  • The purpose of a liquidation preference is to provide preferred stockholders with priority over common stockholders in the distribution of a company's assets upon liquidation or acquisition. This contractual right ensures that preferred shareholders receive their investment back, and potentially a multiple of their original investment, before any remaining assets are distributed to common stockholders. This protects the preferred shareholders' downside risk and aligns their interests with the company's success.
• Describe how a liquidation preference can impact a company's ability to raise additional funding.
  • The strength of a company's liquidation preference can significantly impact its ability to raise additional funding, particularly from new investors. A strong liquidation preference, where preferred stockholders have a higher claim on assets, can make it less attractive for new investors to participate in future funding rounds. This is because the new investors' potential payouts may be diminished if the company is acquired or liquidated, as the preferred shareholders would receive their full liquidation preference before the common stockholders and new investors. As a result, companies must carefully balance the interests of existing and new investors when structuring their liquidation preference terms.
• Analyze the potential conflicts that can arise between preferred and common stockholders due to differing liquidation preference rights.
  • The differing liquidation preference rights between preferred and common stockholders can create potential conflicts of interest. Preferred stockholders, who have priority in receiving payouts, may be incentivized to pursue a liquidity event, such as an acquisition, even if it does not maximize the long-term value of the company. This is because their liquidation preference guarantees them a minimum return on their investment, while common stockholders may be left with little or no payout. Conversely, common stockholders may prefer to continue operating the business and growing its value, rather than accepting a lower-than-optimal acquisition offer that primarily benefits the preferred shareholders. Navigating these conflicting interests is a critical challenge for company management and boards of directors when considering strategic decisions that may trigger a liquidation preference.

Related terms

Preferred Stock: A class of ownership in a corporation that has a higher claim on the company's assets and earnings than common stock. Preferred stockholders typically have priority in receiving dividends and a greater claim on assets in the event of liquidation.

Liquidation: The process of dissolving a company and distributing its assets to creditors and shareholders. This occurs when a company is unable to continue operating or when the owners decide to shut down the business.

Acquisition: The purchase of one company by another, resulting in the combination of the two entities. An acquisition can trigger a liquidation preference event for certain shareholders.