Liquidation Preference Definition
Liquidation preference is a clause that states the order of payment from the realization of assets in case the entity loses its corporate status and becomes bankrupt. This is done to provide protection of the invested amount by the preferred shareholders in case the entity goes under the liquidation process, whether voluntary or involuntary.
What is Liquidation?
Liquidation, in layman’s term, is an end of the company. It also means transferring the company to other hands or selling the business. In the process of liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order., the company needs to cash all its assets, pay off the liabilities, and to distribute the funds to various claimants, including investors, with the liquidation preference title. This clause is generally used by venture capital investors to protect their investments.
Process of Liquidation Preference
The following process is being followed for the investors with the Liquidation preference clause.
- First of all, it needs to be checked that the investor is a preferred investor or just a common stockholder such as an employee or other stakeholders, he will be entitled to receive the receipts as other shareholders would share it.
- Then, we need to look into the multiple allotted to their invested capital. Multiple denotes the times of investment would be received in case the company exits. Generally, it ranges between 1-3, and If no multiple is attached, the investor won’t be able to get its share of proceeds based on Liquidation Preference.
- We also need to check whether the preferential investor does have a participating right or not. Participating right entitles the investor to share the proceeds in addition to its liquidation preference and as a common stakeholder-based upon the percentage of his holding. And, if the investor is also a participating right holder, he will receive the additional amount. Otherwise, he will only receive the funds for his liquidation Preference.
Types of Liquidation Preference
There are multiple types that are floating in the market; we will cover some important ones:
- Liquidation Preference Multiple is one of the most famous ways in which investors protect themselves in case of liquidation. It states the amount which would be repaid in multiple of the capital invested by the investors. Let’s say someone invested $1M, and his liquidation preference is 1, then, if adequate funds have been generated from liquidating the entity, he will receive his initial investment back, i.e., $1M.
- In the case of Participating Liquidation Preference, investors would receive an additional amount from the equity ownership after it has been paid off.
- In Straight or Non-Participating Liquidation Preference, if an investor has a preferred stock with non-participating preference, then he is eligible for a higher return in the following options; he can choose to either convert his preferred stock into common stock and receive proceeds or to just receive his entitlement from preferred stock only.
- The Capped Liquidation Process is also widely used. Here the investor and entity get equal benefits. If an investor has this preference, then he will be eligible to receive the preference amount and then the additional amount from common equity, but his earnings would be capped to a limit, as mentioned in terms of the contract.
- Some liquidation preference does exist based on seniority too. Such as:
- When there is a clause mentioned in the contract based on seniority level, then-latest tranche of investor preference would be considered over the earlier ones in repayments.
- In the case of Pari Passu Seniority, the proceeds would be equally distributed in all the investor with this preference in the ratio of their investments, if the receipts are unable to pay back all in full.
- There is one more type of Seniority preference, and that is known as Hybrid or Tiered Seniority. Here the investors are pooled together and paid according to the pari passu principle.
Example of Liquidation Preference
Let’s assume a Venture Capital Group has invested $250M for a 50% share in the business. It has a non- participating liquidation preference right in the ratio of say 0/1/2/3 of its investment value. At a later date, the business is being acquired for 100/250/500/1000 million. The venture capitalist would be entitled to the proceeds as follows:
In the above example, if the venture capital group is also entitled to a share in the proceeds or it has a participating share as well, then the additional share will be paid after the liquidation preference. The Venture Capital Group would receive the ownership proceeds as per the following formula:
Refer to the excel sheet for the detailed calculation.
This preference acts as insurance to investors. If the company could not meet its target or fails in its venture, then it needs to be liquidated. Hence, the investors have the preference or guarantee of funds; they would be able to get at least their invested amount.
The liquidation preference is applicable only when a company goes into liquidation due to bankruptcy, recapitalizationRecapitalizationA recapitalization is a method of restructuring the ratios of various capital-generating modes, such as debt, equity, and preference shares, based on WACC and other company requirements, such as desired control level., or does merger and acquisition, etc. But, the investor preference is not applicable if the company takes out an Initial Public OfferInitial Public OfferInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes.. In this case, generally, all the preference shareholders are being converted to the common shareholders.
Overall, the Investor Preference clause helps the investor to protect their investments in case of liquidation of the company, where the proceeds are quite scarce. Otherwise, it helps the investor to clock some extra gains when the proceeds at which the company is liquidated are more than sufficient to cover its expenses.
This has been a guide to Liquidation Preference and its definition. Here we discuss the process of liquidation preference clause along with its types and example. You can learn more from the following investment banking articles –