Legal Definitions - liquidation preference

A liquidation preference is a contractual right, typically granted to investors who hold preferred stock in a company. It specifies that in the event of a "liquidation event" – which can include the sale of the company, a merger, or bankruptcy – these preferred shareholders will receive a certain amount of money back from the company's assets before common shareholders receive any distribution. This right serves to protect early investors by ensuring they recover their initial investment, and sometimes a multiple of it, before other equity holders.

• Startup Acquisition: Imagine a software startup, InnovateTech, raises $5 million from a venture capital firm, Alpha Ventures, in exchange for preferred stock with a 1x liquidation preference. This means Alpha Ventures is entitled to get its $5 million back first. Later, InnovateTech is acquired by a larger tech company for $20 million.

  How it illustrates the term: Before any of the common shareholders (like the founders and employees) receive their share of the $20 million acquisition price, Alpha Ventures, as the preferred shareholder, receives its initial $5 million investment back due to its liquidation preference. The remaining $15 million is then distributed among all shareholders, including common shareholders.

• Company Bankruptcy: Consider GreenEnergy Solutions, a renewable energy company that secured $2 million from angel investors for preferred stock with a 1.5x liquidation preference. This means the angel investors are entitled to $3 million ($2 million * 1.5) before common shareholders. Unfortunately, the company struggles and declares bankruptcy. After paying off secured creditors, the company's remaining assets are sold for $4 million.

  How it illustrates the term: In this liquidation scenario, the angel investors, holding the liquidation preference, are paid their $3 million first from the $4 million proceeds. Only the remaining $1 million would then be available for distribution to the common shareholders, demonstrating how the preference prioritizes certain investors in an unfavorable outcome.

• Strategic Merger: A medical device company, HealthLink Diagnostics, receives a $10 million investment from a private equity firm, Growth Capital, for preferred stock with a 2x liquidation preference. This means Growth Capital is entitled to $20 million before common shareholders. A few years later, HealthLink Diagnostics merges with a larger competitor, and the deal is valued at $30 million for distribution to shareholders.

  How it illustrates the term: Due to its liquidation preference, Growth Capital receives its $20 million (2x its initial $10 million investment) from the $30 million merger proceeds before any funds are distributed to the common shareholders. The remaining $10 million is then allocated to the common shareholders, highlighting how the preference ensures a significant return for preferred investors in a strategic exit.