What Is Liquidation Preference?
The moment you think of starting a business, you open yourself up to a whole new world of business decisions. You find yourself asking questions like, how do startups pay employees? If your business still needs to grow, you may start searching for investors online. Many startup founders find comfort in the fact that if the company succeeds, stakeholders will be smiling all the way to the bank. But if it doesn’t, investors aren’t entitled to demand money back that’s not there. Although, you should know that if your business fails, you may not always be off the hook. Prudent investors take the necessary precautions in case a company hits rock bottom. For example, a liquidation preference clause in the business contract ensures that they don't walk away empty-handed if the start-up sinks.
So, what is liquidation preference? It’s a clause included in the business contract outlining the order of payout in the event of company liquidation. We’ll unpack this concept further so that you know what it entails and what to expect.
Liquidation Preference Explained
Just as you may wrack your brain wondering, “How much ownership should an investor get?”, you should also know what’s at stake when things go south. As mentioned, investors often include a clause termed liquidation preference in the business contract. It outlines how the investor holding preference stock should be first in line to receive any money back before common stockholders should the company need to liquidate its assets. Company founders and employees fall under the latter bracket.
As you can imagine, it's one of the most crucial clauses that impact an investor's overall returns. Instead of merely highlighting the order of payouts, the clause also states the amount payable to the investor in the face of liquidation before the founders can get a payout. In a nutshell, if you shut down or sell your company, investors get a share of the money first.
Why is Liquidation Preference Necessary?
Put simply, liquidation preference is there to protect the investor. As you know, investing in a business is a huge risk. Depending on the skills and expertise of the business owner, the company might sail to great heights or come crashing down. Without a liquidation preference in place, an investor is at a risk of losing every penny they have put into the business.
If for whatever reason, the company goes out of business or has to be sold, liquidation preference ensures that the investor can salvage something out of the deal. And that's regardless of whether the company sells or liquidates at a value lower than expected. It eliminates or limits the risk of investors losing out on all their money. In addition, it gives the investor some form of security when they know their position in the repayment schedule.
Types Of Liquidation Preference
The concept of liquidation preference isn't one-size-fits-all. There are a few variations to keep in mind when evaluating liquidation preference as outlined below:
Liquidation Preference Multiple: Liquidation preference is often expressed as a multiple of the investment, such as 1x, 2x, or 3x. The most common multiple is 1x. That means the investor should receive his investment in full before other equity holders.
Non participating liquidation preference: In this case, the investor can receive their share, even if it's below the expected value. Or, they can convert their stock into common stock and receive the funds after company valuation.
Participating liquidation preference: In this case, the investor can choose to receive their share after liquidation as well as a percentage of the common stock after company valuation.
Capped liquidation preference: With this kind of preference, a limit is capped on the amount the investor can receive. That approach works in the favor of common stockholders, if the company sells after performing relatively well.
Seniority: Here, liquidation preference is paid in order of last money in and first money out. Such a clause is usually adopted by new startups.
Conclusion
Even though it's not the end you're hoping for, businesses do fail due to various reasons. When this happens, investors lose their money if they hadn’t made provisions for such eventualities. To mitigate this risk, investors throw in what's known as liquidation preference. This clause gives them preference when it comes to collecting funds after the company is liquidated.