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Liquidation preference determines who gets first and how much when the company is liquidated, sold, or declares bankruptcy. Liquidation preference is associated with
the preferred convertible stock. It explains how the proceeds are divided and shared.
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For example, a holder of preferred stock has a liquidation preference equal to $30 million and the company is sold. Then the holder will get the first $30 million before the
common stockholders receive any amounts.
When the company liquidates, liquidation preferences are one of the special rights of investors. The owner of a preferred stock gets a guaranteed amount of money from
the sale. The investors receive a guaranteed amount of 1X of their investment, depending on the negotiation between the investor and the company owner.
Sometimes the multiplier goes higher as part of the negotiation. This is called the multiple liquidation preferences (e.g., 2X multiple, 3X multiple, etc). This means an
investor will get double or triple of the amount invested.
Liquidation preference also provides companies or businesses an ease on prioritizing who gets paid first and how much.
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Companies can easily close investor deals and can boost business growth.
For example, an investor or venture capital company invests $1 million in a startup company. This is in exchange for 50 percent of the common stock and a $500,000 for
the preferred stock with a liquidation preference of 1x. The owner or founder also invests $500,000 for the other 50 percent of the common stock. This equals a total of $2
million capital investment.
If the company declares bankruptcy and sells the company for $3 million, the venture capitalist will get $2 million out of the $1 million common stock and the $500,000
preferred stock. The company's owner will receive $1 million out of the $500,000 investment.
Another example shows the advantage for the capitalist or investor with the liquidation preference. A capitalist invests $1 million preferred stock with a liquidation
preference of 1X. The owner provides a $500,000 common stock with a total investment of $1.5 million.
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Due to losses, the company was forced to declare bankruptcy and sold the company for only $1 million. The capitalist is ensured of his or her $1 million investment.
However, the owner will get nothing from the proceeds of the sale.
A common stock is the basic form of equity in the company. Usually, the company's founders or owners, as well as its employees, hold common stocks.
A preferred stock has more interest in the company. It can offer aspects such as dividends or voting rights. Typically, venture capitalists and investors in the
company hold preferred stocks.
1. Nonparticipating or Straight Preferred Stock. This particular liquidation preference is favorable for business owners or companies. In cases where
companies fall into liquidation, the holder of preferred stock will get his or her initial investment. However, the owner will not share in the liquidation
proceeds based on the percentage with the common stocks.
2. Fully Participating or Double-dip Preferred Stock. This liquidation preference favors the investor. Similar to the nonparticipating or straight preferred, the
investor will receive liquidation proceeds based on a percentage of the common stocks after receiving the initial investment.
3. Capped or Partially Participating Preferred Stock. This type of liquidation preference is often viewed as an intermediate approach. But their aggregate
return is capped. Once the investors received their capped amount, they can no longer share in the remaining proceeds with the other common stockholders.
The liquidation preference is important in providing security for the risk that investors make in giving a large amount of money to finance a company or business. It
ensures they have the first rights to gain back their investments, should the company liquidate.
No, it isn't unfair. For the people who bring the capital to a company, a 1X liquidation preference is a fair protection for their investment. It is their collateral for the
risk they take in investing in a company. But it is something that employees should know about and follow. Otherwise, it could lead to a disaster in the liquidation
process.
If you have any questions about liquidation preference, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to
its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law, and they average 14 years of legal experience. Their work included assisting
companies such as Google, Charming Charlie, and Airbnb.
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