Liquidation Preference

What it is

A liquidation preference is a contractual right that determines the order and amount of payments to investors and creditors when a company is sold, goes bankrupt, or undergoes another liquidation event. It gives preferred shareholders priority over common shareholders and can protect investors (especially venture capitalists) by ensuring they recover some or all of their investment before others receive proceeds.

How it works

• A company’s liquidator or responsible party reviews secured and unsecured loan agreements and the company’s share capital terms (preferred vs. common stock) to establish payment order.
• Payment priority typically follows this order:
• Secured creditors (lenders with specific collateral/liens)
• Unsecured creditors (general debt holders)
• Preferred shareholders with liquidation preferences
• Common shareholders (founders, employees, other common-stock holders)
• In venture capital deals, a sale of the company is often treated as a “liquidation event,” so liquidation preferences can apply even if there is no bankruptcy.

Typical uses in venture capital

• Venture investors commonly negotiate liquidation preferences to reduce downside risk and ensure they get their invested capital back before common shareholders.
• Preferences can also affect how profit from a sale is distributed: preferred holders may be first in line to claim proceeds, which can alter payouts to founders and employees.

Example

Assume:
– A venture firm has a liquidation preference that entitles it to $1,000,000.
– The firm also owns 50% of the company’s common stock; the founders own the other 50%.

Outcomes:
– If the company sells for $3,000,000:
– The investor receives $1,000,000 (preference) + 50% of the remaining $2,000,000 (= $1,000,000), for a total of $2,000,000.
– The founders receive the remaining $1,000,000.
– If the company sells for $1,000,000:
– The investor receives $1,000,000 (preference).
– The founders receive nothing.

Creditor priority and liens

Liquidation preference also applies more broadly in insolvency: secured creditors with liens on specific assets are paid from the proceeds of those assets first; senior creditors are paid before junior creditors; shareholders are last. This ranking is enforced by the liquidator when assets are sold and proceeds distributed.

Implications

• For investors: liquidation preferences limit downside risk by prioritizing return of invested capital.
• For founders and employees: preferences can reduce upside on a sale, especially in low- to mid-value outcomes, because preferred holders get paid before common shareholders share in proceeds.
• For deal negotiation: terms such as multiple-of-investment preferences, participating vs. non-participating preferences, and seniority levels materially affect payout outcomes and should be negotiated and understood.

Key takeaways

• Liquidation preference specifies who gets paid first and how much when a company is sold or liquidated.
• Preferred shareholders (often VCs) typically have priority over common shareholders.
• A sale can be treated as a liquidation event, so preferences apply even absent bankruptcy.
• Understanding the specific preference terms is essential for founders and investors because they directly influence distribution of sale proceeds and risk allocation.