When a company goes bankrupt, the order in which lenders and equity owners are repaid becomes very important.
When a company goes out of business, it will go through the process of liquidation, which involves converting all of its assets to cash and then distributing them to the various stakeholders, including lenders and equity owners. The entire process of liquidation can take several years, and it may sometimes be difficult for a business to receive the full value of its assets.
Winding Up
The first step in the process of a company's liquidation is the winding up of its business affairs. A company that makes the decision to go out of business typically cannot simply close its doors that same day. Generally, companies have long-term commitments and relationships that must be concluded before the company can completely cease its existence as a going concern.
Asset Liquidation
Once a company has wound up its affairs, it must then convert its assets to cash. These assets can include the equipment used in the company, the land and buildings the company uses and any remaining inventory or raw materials. It is rare that a company will be able to liquidate its assets for their full true value. This is particularly the case when the company has specialized assets such as equipment used to produce a specific product.
Repayment of Creditors
Once the assets of the company have been converted to cash, the company must pay off any debts it still has outstanding. Lenders are ranked in a hierarchy depending on how subordinated their debt is. At the top of the hierarchy is the lender whose debt is not subordinate to any other lenders. Once that lender is repaid, the remaining assets are used to pay the other creditors in order from least subordinated to most subordinated.
Distribution of Remainging Assets
After all debt has been repaid, any remaining assets belong to the owners of the company. Those owners have rights to the remaining assets in proportion to their level of ownership in the company, in the absence of any valid agreements otherwise. If different classes of stock are involved, preferred stock is repaid before common stock.
