Also known as absolute priority, a liquidation preference is a formula that defines the order of payment when a business is in the process of liquidating. This type of preference typically dictates that the claims of creditors are addressed and resolved before any disbursements are made to shareholders. Even among shareholders, the process of liquidation preference requires that holders of specific types of shares receive compensation before investors holding other types of shares receive any benefit from the sale of the company’s assets.
One of the benefits to the liquidation preference is that creditors have first claim on any funds generated by the sale of company assets. This means that if a company is either shutting down or going bankrupt, and the current cash reserves are not sufficient to settle outstanding debts, enough assets are sold to settle those debts. Creditors are granted priority over shareholders, meaning that they receive payment ahead of anyone else. By protecting the investment that vendors and lenders make in a business by extending credit to that company, the law of liquidation preference actually makes it easier for businesses to buy necessary goods and services without paying cash up front.
The concept of liquidation preference also means that investors who are holding shares of preferred stock receive some type of settlement or compensation before investors with shares of common stock. This is usually because investors who choose to purchase preferred shares understand they are accepting a greater degree of risk in exchange for the possibility of earning larger returns than would be possible with shares of common stock. As part of the terms related to preferred stock, investors have the assurance that in the event the company goes under, the chances of recovering a greater portion of their investments is better than the chances of those with common stock options.
While businesses usually do not intend to fail, investors should look carefully at the potential of any business before making any type of investment. This is especially true for venture capitalists who invest funds in businesses with significant potential but usually very little in the way of a proven track record. In this scenario, the investor participating in a venture capital strategy would do well to understand what rights the company has to convert preferred shares into common stock prior to the beginning of the liquidation process, as this type of move could reduce the amount of compensation received once the liquidation preference is invoked.