What is meant by liquidation preference?

Liquidation preference refers to the order of payments to different classes of investors during a liquidation event. This is a critical concept in financial restructuring and investment, particularly in scenarios where a company is being dissolved or its assets are being sold off.

In the context of a liquidation, certain stakeholders—typically preferred equity holders—have a claim to the proceeds before common equity holders. This means that when a company goes into liquidation, creditors and investors with liquidation preferences receive their payments according to their priority levels specified in the company’s governing documents. The precedence of these payments ensures that those who have invested or loaned money to the company are compensated first, reflecting their higher priority and risk profile compared to common shareholders.

Understanding liquidation preferences is essential for investors and stakeholders as it directly affects their potential recovery in the event of a company's liquidation. It helps them gauge the risk associated with their investment and the likely return on that investment, especially in distressed situations. Hence, recognizing the importance of payment order during liquidation is key to navigating potential restructuring scenarios effectively.