Definition of liquidation (business): The winding up of a company by realising the cash value of its assets to settle its liabilities.
What is liquidation?
Liquidation is a word which means to wind up or closing a company. Liquidation can be a very smooth and orderly process, initiated at the request of the directors. In contrast it can also be performed under hostile circumstances at the request of creditors where a company is insolvent.
The precise definition of liquidation will vary by country, as each will have their own laws and procedures surrounding the winding up and bankruptcy of businesses.
Other useful terms commonly associated with liquidation are:
This article will explain the British definition of the word liquidation.
The different types of liquidation
According to HM Government, there are three distinct types of liquidation:
1. Members voluntary liquidation
A members voluntary liquidation is the formal process any solvent company must undertake to properly close and be taken off the register of companies.
This is an orderly affair which will see all liabilities of the company, such as short term creditors and longer-term borrowings (such as debentures and bonds) repaid in full.
After all assets are liquidated (sold), any surplus cash leftover after settling debts will be due to the shareholders, in proportion to their respective holdings of shares in the company.
After liquidation, on the Companies House website, the status of the company will change to ‘dissolved’.
Compulsory liquidation occurs when a company realises it can no longer trade and must cease activity immediately to avoid further losses for shareholders and creditors.
All company directors have a duty to only trade when a business has a hope of recovery. Continuing to trade under circumstances in which losses to stakeholders are certain to only increase, is known as wrongful trading, which can be punishable as a criminal offence.
Under a compulsory liquidation, a majority of 75% of shareholders must agree to the motion before it will be accepted by the courts.
Because creditors may not receive their monies in full, the fair and equitable liquidation of assets and their distribution is of prime importance.
This is why a court will appoint an ‘Official Receiver or authorised insolvency practitioner. These are independent professionals with a legal and accounting background who take control of the liquidation process and ensure that some creditors are not unfairly favoured in an unlawful manner.
Third-party insolvency professionals are remunerated by invoicing the bankrupt company – their invoices are naturally given priority over virtually all others claims on the assets. This helps to protect the practitioner’s independence.
The appointed party formally takes all power away from the existing directors, to ensure that they have complete control over how the funds are distributed.
Creditors voluntary liquidation
A creditors voluntary liquidation is very similar to a compulsory liquidation, with the key difference being that the process is initiated by the creditors themselves applying to the court.
How is the word liquidation used in a sentence?
“The land and buildings subject to the capital expenditure programme last year have been marked for liquidation by the end of March.”
“Following the appointment of the official receiver, the company will be liquidated in due course.”
What else you should know about liquidation
The order of priority in which creditors are paid is very rigid and enshrined in law in the Insolvency Act 1986.
The order of priority is as follows:
Secured creditors with a fixed charge – This refers to banks with mortgages over the property, debenture holders with other secured charges and similar.
Preferential creditors – These include the tax authority and unpaid employees.
Secured creditors with a floating charge – Floating charges are not attached to a specific asset, but rather give an entitlement for the lender to seize some assets of the business to recoup their debts. Once the liquidation process begins, floating charge holders are prevented from exercising their right to seize assets, however, they are given priority over unsecured creditors.
Unsecured creditors – These include all other parties, such as suppliers, utility providers and other local authorities, plus unsecured debts such as an overdraft.
Shareholders – equity holders only see a penny of cash if all claims above have been satisfied in full.
How does the definition of liquidation relate to investing?
As any investment book or investment course will explain, buying shares in small private companies is a very high-risk investment activity which is only appropriate for investors with a very high-risk tolerance and a long time horizon.
It’s quite rare for large corporate businesses to enter liquidation, but each year you will recognise several high-profile company names enter the process if they run out of cash and fail.
A business will usually seek to trade their way out of a bleak financial situation by entering administration first. This is an extreme measure which provides court protection from creditor claims for a short period. This buys the company some time to raise funds and re-organise their operations before creditors can seize assets which may otherwise undermine a businesses’ entire operation.