Liquidation rights: Overview, definition, and example
What are liquidation rights?
Liquidation rights refer to the entitlements or claims that a shareholder, partner, or investor has to a company’s assets in the event of the company’s liquidation or winding up. Liquidation occurs when a business is dissolved and its assets are sold to pay off debts. The liquidation rights determine the order in which stakeholders receive payment, with certain parties (such as creditors) having priority over others (such as shareholders or partners). These rights are often outlined in a company’s governing documents, such as its articles of incorporation or partnership agreement.
For example, in the event of a company's liquidation, liquidation rights specify how the proceeds from the sale of assets will be distributed among the company’s creditors and shareholders.
Why are liquidation rights important?
Liquidation rights are important because they define the financial priority and order of payment in the event that a company goes out of business or is dissolved. These rights ensure that creditors are paid first, followed by shareholders or partners, according to their class of stock or partnership interest. For investors, understanding liquidation rights is crucial to understanding their potential return in a liquidation scenario. For businesses, liquidation rights help set expectations and provide clarity on how assets will be distributed if the company is forced to close.
For creditors, liquidation rights provide legal protection by establishing priority claims to assets. For equity holders, the rights outline how much of the remaining assets (if any) they may be entitled to once higher-priority claims are satisfied.
Understanding liquidation rights through an example
Imagine a tech startup that goes into liquidation. The company has $1 million in assets, but it also has $700,000 in outstanding debts to creditors. After selling the company’s assets, the creditors will be paid first, based on the liquidation rights they hold. If the company’s articles of incorporation state that creditors are entitled to the entire $700,000 in the event of liquidation, the remaining $300,000 would be distributed to the shareholders, depending on their ownership stake and the terms of their shares.
In another example, a private equity firm owns 40% of a company. The company goes into liquidation, and the firm’s liquidation rights allow them to receive a proportionate share of the remaining assets, after creditors have been paid. If the company has $500,000 left after clearing its debts, the equity firm would receive 40% of that amount, or $200,000, under its liquidation rights.
An example of a liquidation rights clause
Here’s how a liquidation rights clause might appear in a shareholder agreement or company bylaws:
“In the event of liquidation or winding up of the Company, the assets of the Company shall be distributed in the following order: (i) first, to pay all debts and liabilities of the Company, (ii) second, to holders of preferred shares in proportion to the liquidation preference, and (iii) third, to holders of common shares, in proportion to the number of shares held. Any remaining assets shall be distributed to the shareholders after all debts have been settled.”
Conclusion
Liquidation rights are critical provisions that outline how a company’s remaining assets are to be distributed when it is liquidated. These rights protect creditors by giving them priority over shareholders and ensure that equity holders understand their potential return in the event of liquidation. Whether for investors, creditors, or business owners, clearly defined liquidation rights provide clarity, reduce disputes, and help stakeholders understand their financial entitlements during liquidation or dissolution scenarios.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.