Absolute priority

Definition: The rule which says that, with regard to being paid back, lenders and creditors to a corporation get in line ahead of shareholders in the unfortunate event that a company goes out of business. Lenders and creditors are paid back with the money received from the sale of the company’s assets, called liquidation. Only after the lenders and creditors are fully paid will any money be paid to shareholders.

Example: JRF Corporation, which has fallen behind its competition in recent years, announces that it is going out of business. The company previously borrowed $1 million by selling that amount of bonds. The company had also previously obtained another $1 million by selling that amount of stock. JRF sells everything it owns, including the desks, chairs, file cabinets, computers, and the company coffee maker!

Adding all the cash it got from selling the assets to the amount of money the company already in the bank brings the total to $1,000,000. This $1,000,000 will be paid to the bondholders. The stockholders will get nothing!

Investeach explains: When a company goes out of business, it usually does not have enough assets to sell to pay back both the lenders / creditors and the shareholders. Therefore, where each party gets in line is very important.

Lenders to a corporation aren’t owners. They’re only entitled to receive interest and, of course, to eventually be paid back the money they lent to the company. Note that lenders don’t have any real “upside”. If the company they loaned money to thrives, this doesn’t mean they get paid any more interest.

Stockholders, on the other hand, do have an upside. For one, their stock can dramatically increase in value when the company does well. It only makes sense that if something bad happens to the corporation, the bondholder shouldn’t have as much “downside” as the shareholders should. This is indeed the case.

Riddle me this:

  1. Why do bondholders and lenders to a company have priority over shareholders?
  2. At what time in a corporations life is the concept of absolute priority important?
  3. When a company goes out of business, how does it get cash to pay off creditors and lenders?