Liquidation Preference
Quick Facts
- Standard: 1x non-participating (founder-friendly)
- Aggressive: 2x+ participating ("double dip")
- Trigger events: Acquisition, IPO, or company liquidation
- Trend: Deals with 2x+ preferences rose from 2.3% (2021) to 5.5% (2023)
A liquidation preference determines the order and amount investors receive when a company has a "liquidity event"—typically an acquisition, merger, or liquidation. Investors with liquidation preferences get paid before common shareholders (founders, employees), ensuring they recover their investment even if the exit value is lower than expected.
In Plain English
Liquidation preference is the pecking order for who gets paid when your company sells. VCs negotiate to be first in line. If the sale price is lower than expected, they get their money back before founders see a dime. It's insurance for investors—and it can devastate founders in a bad exit.
How It Works
Example: $50M exit for a company that raised $20M at 1x preference
- Investors paid first: $20M goes to preferred shareholders
- Remainder distributed: $30M split among common shareholders
- Founders get paid: Only after investors are made whole
But if the exit is only $15M:
- Investors get $15M (all available proceeds)
- Founders get $0 (nothing left after preferences)
The Preference Multiple (1x, 2x, 3x)
The multiple determines how much investors receive before common shareholders:
| Multiple | $10M Investment Returns | Before Common Gets Anything |
|---|---|---|
| 1x | $10M | $10M |
| 2x | $20M | $20M |
| 3x | $30M | $30M |
1x is standard for most venture deals. Higher multiples (2x, 3x) appear in:
- Down rounds where investors need extra protection
- Bridge financing with higher risk
- Later-stage deals with more conservative investors
Participating vs. Non-Participating
This is where liquidation preferences get complicated—and where founders often get burned.
Non-Participating Preferred (Standard)
Investors choose the greater of:
- Their liquidation preference amount, OR
- Their pro-rata share as if converted to common stock
Example: Investor owns 20% with $10M invested (1x preference)
- $100M exit: Takes $20M (20% of proceeds) — conversion is better
- $30M exit: Takes $10M preference — preference is better
Non-participating is founder-friendly because investors don't "double dip."
Participating Preferred ("Double Dip")
Investors get both:
- Their full liquidation preference, AND
- Their pro-rata share of remaining proceeds
Example: Same investor (20%, $10M invested, 1x participating)
- $100M exit: Takes $10M preference + 20% of remaining $90M = $28M total
- $30M exit: Takes $10M preference + 20% of remaining $20M = $14M total
Participating preferred is investor-friendly and significantly reduces founder returns.
Capped Participation
A compromise: participation is capped at a multiple (usually 2-3x the investment).
Example: 1x participating, capped at 3x
- Investor gets preference + participation until total reaches 3x investment
- Beyond the cap, only common shareholders receive additional proceeds
Stacking (Multiple Rounds)
When companies raise multiple rounds, preferences "stack" in reverse order:
| Round | Raised | Preference |
|---|---|---|
| Series C | $30M | Paid 1st |
| Series B | $15M | Paid 2nd |
| Series A | $5M | Paid 3rd |
| Common | — | Paid last |
In a $40M exit:
- Series C gets $30M
- Series B gets $10M
- Series A and Common get $0
This is why later-stage investors sometimes do well even in "bad" exits, while founders and early employees get wiped out.
Real-World Impact
Square (2015)
Square went public at $9 per share—below its last private round price of $15.46. Late-stage investors had ratchet provisions that protected them, diluting earlier shareholders and employees significantly.
Good Technology (2015)
Good Technology was acquired by BlackBerry for $425M—well below its $1.1B valuation. Due to liquidation preferences, common shareholders (including many employees) received almost nothing, while preferred shareholders recovered most of their investment.
Negotiating Liquidation Preferences
Founders Should Push For:
- 1x non-participating: The founder-friendly standard
- No stacking: Pari passu (equal) treatment across rounds
- Carve-outs: Minimum amount reserved for common shareholders
- Cap on participation: If participation is unavoidable, negotiate a cap
Investors Typically Want:
- 1x minimum: Standard downside protection
- Participation: In riskier or later-stage deals
- Seniority: Their round paid before earlier rounds
When Preferences Disappear
Liquidation preferences typically convert to common stock in an IPO, since:
- Public markets don't have preference stacks
- Investors want liquidity and freely tradable shares
- Conversion often triggers automatically above certain valuations
Preference Analysis: Same Exit, Different Terms
$50M exit, investor owns 30%, invested $15M
| Structure | Investor Gets | Founders Get |
|---|---|---|
| 1x Non-Participating | $15M | $35M |
| 1x Participating | $25.5M | $24.5M |
| 2x Non-Participating | $30M | $20M |
| 2x Participating | $36M | $14M |
The structure matters enormously.
Practical Takeaways
For founders: Liquidation preferences are one of the most important terms you'll negotiate. Fight for 1x non-participating and resist participation at all costs. If an investor demands 2x+ or participating terms, understand exactly how it affects your payout scenarios—and consider whether the deal is worth it.
For investors: Liquidation preferences are essential downside protection. But overly aggressive terms can misalign incentives—founders may lose motivation if preferences mean they won't benefit from a modest exit. Consider whether 1x non-participating provides sufficient protection while keeping founders engaged.
Related Reading
- Anti-Dilution Provisions — Another term that shifts value between investors and founders
- Drag-Along Rights — How exits get forced when preferences are in play
- Tender Offer — Another path to liquidity in private companies