Remember the days of the single-screen movie theater before the proliferation of the multiplex? Remember those lines that snaked on forever for big blockbusters like Star Wars, ET and Rocky? You’d follow the line around one corner of the building only to be disappointed to find that the line continued on to the next corner. You soldiered on to the next corner only to suffer further disappointment as the line continued down the block. At that point, you weren’t sure there would be any tickets left since it was a first come first serve system back then.
There’s an analog in the financial world to this bygone movie era. For equity owners in a company, like stockholders of corporations and LLC members, in a bankruptcy or other corporate dissolution, it’s to the end of the line for any hope of a piece of the remaining pie. And just as it is in the case of a movie with limited tickets and a long line, those at the end of the line will likely end up empty-handed.
Equity has its benefits. If the company succeeds, the equity holder benefits from appreciation and in some cases profit distributions. But, if things go south, equity owners, such as stockholders and LLC members, go to the back of the line. Some of these owners are shocked that they’re last in priority in bankruptcy, mistakenly assuming that ownership came with a warranty, not realizing that the potential upside came with a similar amount of downside risk.
When a company goes bankrupt or liquidates for any reason, it sells off its remaining assets to pay off as much of its debts as possible. In the eyes of bankruptcy law, not all debts and not all creditors are equal in priority.
The bankrupt company must pay off its creditors and shareholders according to an order set by federal laws and creditors always come first and shareholders last.
Here is a list of priority according to federal law:
1. Bankruptcy Costs
In bankruptcy, it shouldn’t be surprising that the first to get paid are the lawyers and court-appointed trustees. Otherwise, the groups handling the bankruptcy would have no incentive to handle the process. They know they have a rotting carcass to divide among a pride of hungry lions and if they don’t get paid first, there will be nothing left to pay them. This group includes the law firm hired to handle the bankruptcy, the accountant who administers the company’s final accounting duties, the auction service tasked with selling the company’s property and the court costs associated with bankruptcy.
2. Secured Creditors
After payment of the bankruptcy costs, secured creditors are the first in line for any payouts. Secured creditors provide loans secured by collateral – the very assets being auctioned off. By virtue of their beneficial ownership of these assets, secured creditors are first in line for any distributions. These secured loans include debts like the mortgage on company buildings, leases on company cars and loans for equipment. Secured creditors get their money back first.
3. Unsecured Creditors
After the secured creditors, unsecured creditors are next in line and even among the unsecured creditors, there are tiers of priorities. The first tier of unsecured creditors are those who are entitled to receive money from the company, but their claims are not secured or guaranteed. This group of creditors includes bank lenders, employees, the government (unpaid taxes), suppliers and investors who have unsecured bonds.
The second tier of unsecured creditors is the general creditors, which is largely made up of stockholders and LLC members and even among these general creditors, common stockholders and non-preferred LLC Members are the absolute last in line. General creditors are only paid if there is any money left over after all the other creditors have been paid.
The general creditors are divided into creditors who have preferred stock and those who have common stock. Preferred shareholders are paid before those who have common shares. If there is no money after the preferred shareholders are paid, then the common shareholders do not receive any money.
In 90% of cases, any remaining money doesn’t even reach the unsecured creditor level, let alone the general creditor level.
The bottom line is, although stockholders can potentially enjoy substantial upside from their investment, the flip side, as owners, they also assume greater risks. If things go well the shareholder benefits; but in exchange for the upside, the shareholder takes the risk that what they’ve invested will be lost if the company fails. It comes with the territory of ownership.