Question: What is a liquidation preference?Answer:
A liquidation preference is a right that can attach to a share. ‘Liquidation preference’ refers to the prioritisation of a particular shareholder in the event that the company goes into liquidation.
A liquidation preference is typically a multiple of the initial investment (the price per share) of the investor. It is not uncommon to see liquidation preferences of 1x or 2x, but any multiple is possible (although perhaps, commercially unlikely). The 1x and 2x refer to the multiplication of the initial investment sum (price per share) by that number in the event of liquidation.
When a company goes into liquidation, it ceases to operate. Before distribution to creditors in order of priority, assets of the company convert into cash. The order of priority is determined by the Corporations Act 2001 (Cth), but can be varied by creditors that have a security interest over assets of the company.
There are two common types of liquidation preference – participating and non-participating. The difference between these two types of liquidation preferences are the requirements of the shareholder.
Participating preference shares
If a shareholder holds participating shares, they have the opportunity to convert any remaining shares into ordinary shares once their initial liquidation preference has been paid out first. This can offer a shareholder a greater return on their initial investment.
Non-participating preference shares
If a shareholder holds non-participating shares, there is a requirement for them to either convert to ordinary shares at first instance (to potentially increase their payout) or to receive a multiple of the initial price they paid per share (their liquidation preference).