Quick facts
- Market standard: 1x non-participating
- Investor-friendly variants: higher multiples, participation, seniority
- When it applies: acquisition, merger, or wind-down
- Who it affects most: common stock, which means founders and employees
A liquidation preference is the amount a class of preferred stock is entitled to receive before anything is distributed to holders of a junior security, which in a startup means common stock.1 Investors hold preferred stock. Founders and employees hold common. So the preference decides the order of the queue, and in a disappointing sale it decides whether there is anything left when the queue reaches you.
In plain English
When your company is sold, the money does not get split by ownership percentage. It gets paid out in a sequence written into your charter. Investors negotiated to be near the front. If the price is high, the sequence barely matters. If the price is low, the sequence is the only thing that matters.
The basic mechanic
Say you raised $20,000,000 and every investor has a 1x preference, meaning they are entitled to one times what they put in before common stock receives anything.
At a $50,000,000 sale: $20,000,000 goes to preferred, and the remaining $30,000,000 is available to common.
At a $15,000,000 sale: all $15,000,000 goes to preferred, and common receives nothing. Not a reduced amount. Nothing.
The company still sold for real money. Your shares were still real. They simply sat behind $20,000,000 of contractual priority.
The multiple
The multiple sets how much must be paid before common participates.
| Multiple | On a $10,000,000 investment | Paid before common gets anything |
|---|---|---|
| 1x | $10,000,000 | $10,000,000 |
| 2x | $20,000,000 | $20,000,000 |
| 3x | $30,000,000 | $30,000,000 |
1x is the market standard. Multiples above 1x tend to appear when the company has less leverage: down rounds, bridge financings, and rescue deals.
Participating versus non-participating
This is the distinction that decides most founder outcomes, and it is worth slowing down for.
Non-participating
The investor takes whichever is better for them, not both: the preference amount, or the value of their shares if they converted to common stock and took their ownership percentage.
Take an investor who put in $10,000,000 for 20% of the company with a 1x non-participating preference.
- $100,000,000 sale: 20% is $20,000,000, which beats the $10,000,000 preference, so they convert and take $20,000,000.
- $30,000,000 sale: 20% is $6,000,000, which is worse than the preference, so they take the $10,000,000.
They pick one door. This is the founder-friendly version, and it is what "1x non-participating" on a term sheet means.
Participating
The investor takes the preference and then also shares pro rata with common in whatever remains.2 Pro rata here just means in proportion to ownership.
Same investor, same 20%, same $10,000,000, but now participating:
- $100,000,000 sale: $10,000,000 preference, then 20% of the remaining $90,000,000, which is $18,000,000. Total $28,000,000.
- $30,000,000 sale: $10,000,000 preference, then 20% of the remaining $20,000,000, which is $4,000,000. Total $14,000,000.
Both doors. That is why founders call it double dipping, and why the word "participating" is worth more attention than its dullness suggests.
Capped participation
The middle ground. Participation continues until the investor has received some total multiple of their money, often 2x or 3x, after which common takes the rest.
The same sale, four different structures
An investor owns 30% and invested $15,000,000. The company sells for $50,000,000.
| Structure | Investor receives | Left for common |
|---|---|---|
| 1x non-participating | $15,000,000 | $35,000,000 |
| 1x participating | $25,500,000 | $24,500,000 |
| 2x non-participating | $30,000,000 | $20,000,000 |
| 2x participating | $36,000,000 | $14,000,000 |
Nothing changed about the company or the price. Only the words in the charter changed, and common stock went from $35,000,000 to $14,000,000.
Stacking across rounds
Each round adds its own preference. Later investors frequently negotiate seniority, meaning they are paid before earlier rounds.
| Round | Raised | Payment order |
|---|---|---|
| Series C | $30,000,000 | First |
| Series B | $15,000,000 | Second |
| Series A | $5,000,000 | Third |
| Common | Last |
In a $40,000,000 sale, Series C takes $30,000,000, Series B takes the remaining $10,000,000, and Series A and common receive nothing. The alternative to seniority is pari passu treatment, a Latin phrase meaning all preferred shares rank equally and share any shortfall proportionally.
Total preferences accumulated across rounds are sometimes called the preference overhang. Once it exceeds a realistic sale price, common stock is worth close to nothing long before anyone says so out loud.
What this looks like when it goes wrong
BlackBerry acquired Good Technology for $425,000,000 in cash in November 2015.3 That was well below Good's last private valuation of $1,100,000,000. Employee shares that had been valued at $4.32 in September 2014 were worth $0.44 by the time the deal closed, because the lower price combined with investor preferences left very little for common stock. The same documents revealed the board had turned down an all-cash offer of $825,000,000 from CA Technologies earlier that year.4
Some employees had already paid tax on the higher number.
What to negotiate
Ask for 1x non-participating, and treat participation as a price increase rather than a detail. If participation is unavoidable, cap it. Ask for pari passu rather than seniority so a later round cannot leapfrog the queue. And consider a carve-out, a slice of proceeds reserved for common regardless of the waterfall, which is the only term here that protects your team rather than you.
What to do next
Take your current preference stack, add up every dollar of preference including multiples, and compare it to a realistic sale price. If the preferences are larger, you already know what your common stock is worth in that scenario. Then work the sequence properly in the liquidation preference waterfall.
Related reading
- Anti-Dilution Provisions covers another term that moves value from common to preferred
- Drag-Along Rights covers how a sale can be forced while preferences apply
- Down Round covers when harsher preferences appear
- Cap Table covers where the preference stack is recorded