What happens when a publicly traded company runs out of money? Besides broken hearts and dwindling brokerage account balances, bankruptcy court happens. When a company can no longer pay its obligations (like if you couldn’t pay your mortgage), a bankruptcy court could force it to go through a liquidation of its assets.
A liquidation is the sale of all company assets, including buildings, factories, inventory, equipment, and vehicles. The company will attempt to sell everything it can to satisfy its creditors (entities to whom it owes money). Additionally, the liquidation serves the stockholders. However, you’ll see why stockholders typically won’t receive compensation when their company liquidates. Here’s the order of payout during a company’s liquidation:
Unpaid wages
Unpaid taxes
Secured creditors
Unsecured creditors
Junior unsecured creditors
Preferred stockholders
Common stockholders
There can be some confusion from the order of unpaid wages & taxes vs. secured creditors, depending on the source of information. Secured creditors have first rights to the collateral backing the loan. The liquidation priority above applies if the collateral backing the loan is liquidated and does not cover the loan balance.
To demonstrate this, assume a secured creditor is owed $1,000, while $100 of wages and $100 of taxes are outstanding. If the collateral backing the secured loan is liquidated for a total of $600, it all goes to pay back the secured creditor, bringing their loan balance down to $400. Now, the rest of the company’s assets are liquidated for a total of $500. $100 goes to unpaid wages, $100 goes to unpaid taxes, and the remaining $300 goes to the secured creditor. This scenario leaves the secured creditor with $100 unpaid.
The order of unpaid wages & taxes vs. secured creditors is not a heavily tested concept. Questions on the priority of creditors (bondholders) vs. equity holders (stockholders) are much more common on the exam.
When a company liquidates all of its assets, it first pays off any unpaid wages, then unpaid taxes. Next, they attempt to pay back secured creditors. Secured creditors have loaned money to the company, and their loans are backed by a specific form of collateral. If you have a mortgage, your home is the collateral for the loan. The bank will take your house if you can’t repay their loan. Secured creditors of corporations typically have a lien on a building, equipment, or some other corporate assets of value.
Once the secured creditors are repaid, the company will pay back its unsecured creditors if there is extra money left over from the liquidation. These parties lent the company money but didn’t have a lien on any specific asset. Essentially, these are “full faith and credit” loans, which are promises to pay back money without collateral.
Once the unsecured creditors are repaid, the company attempts to pay back its junior unsecured creditors if there is extra money left over from the liquidation. The only difference between unsecured and junior unsecured creditors is their priority in liquidation. Both lent money to the company with no specific lien on any company assets (collateral). Junior unsecured loans are the riskiest type of loan for any creditor to make.
After all creditors are repaid, the company will attempt to pay back its preferred stockholders if any extra money is left over from the liquidation. You’ll learn more about preferred stockholders in the following unit, but they’re a different form of ownership. Their name gives it away, but preferred stock is “preferred” regarding liquidation. They are repaid before any common stockholder is repaid.
Last, after all creditors and preferred stockholders are repaid, the company will attempt to repay common stockholders if any extra money is left over from the liquidation. The key word is ‘if.’ Most of the time, companies only make enough money in their liquidation to pay back a portion of what is due to creditors. Stockholders (preferred and common) are unlikely to receive much if anything at all. Regardless, they still have the right to assets upon liquidation.
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