Meaning
Liquidation hierarchy determines the order of payout to investors during the sale or merger of a firm. A liquidation preference ensures that preferred shareholders receive their initial investment back before any common shareholders see a cent. This mechanism defines the hurdle that the firm must clear to create value for its founders.
It is a staple of venture financing agreements.
Payout Seniority
Priority in the distribution of proceeds allows the holder of this right to exit first. In a situation where the sale price is lower than the total capital raised, common stockholders might receive nothing while preferred holders take all the cash. This structure ensures a return for the capital provider.
The record of these preferences is found in the certificate of incorporation and governs every exit calculation.
Participation Multiplier
Some agreements allow an investor to get their money back and then share in the remaining proceeds. This is known as a participating feature.
Exit Barrier
High totals for these preferences can make a moderate sale unattractive to the management team. If the liquidation preference exceeds the offer price, the incentive to sell disappears. This boundary ensures that the interests of the cap table are understood long before a buyer arrives.
