Liquidation preferences: what you need to know

When a startup achieves a successful exit—whether that be an acquisition, IPO, or secondary sale—founders and employees often dream of large paydays. We’ve all seen the news headlines celebrating nine or ten-figure acquisitions. Everyone must walk away with a payout, right? Not necessarily. 

Before the celebration can begin, there's a complex reality that determines who gets paid, how much, and in what order.

This hierarchy of payouts is governed by a mechanism known as liquidity preferences.

Whether you're a founder raising capital or an investor negotiating terms, understanding how liquidation preferences work can help you set yourself up for a successful financial outcome upon an exit. In this article, we’ll explain how liquidation preferences work and what to watch out for in a term sheet. 

What is a liquidation Preference?

A liquidity preference is a clause that specifies how proceeds from a liquidity event are distributed among shareholders. In most cases, it guarantees that preferred shareholders (typically investors) receive their initial investment—or a multiple of it—before common shareholders (usually founders, employees, and early angels) get anything.

Liquidation preferences generally protect against an investor’s downside risk—that is, if there’s an exit at a lower valuation than the valuation at which they invested. 

However, in an upside scenario, where the exit valuation is higher than the valuation at which an investor came in, liquidation preferences are usually a moot point as investors will simply choose to convert their shares to common stock and take their pro rata share of the net proceeds. Converting your preferred shares to common stock is a typical occurrence when there is an exit event—it simplifies a company’s cap table upon exit, creates one single share class instead of two (or more), and enables shareholders to participate in the sale proceeds. 

Let’s understand a little bit more about how liquidation preferences are structured.

The building blocks of liquidation preferences

1. Seniority and stacking

For startups that have raised multiple rounds of financing, liquidation preferences are often stacked. Later investors (Series B, C, etc.) typically have senior preferences, meaning they get paid before earlier investors.

This creates a waterfall payout effect: exit proceeds cascade from the most senior investor down. If the sale price is low, early investors—and especially founders and employees—might end up with a much lower amount, or in some cases, even nothing.

Some deals use pari passu treatment, where all investors share proceeds proportionally regardless of round. Founders should understand which model and the extent of liquidity preferences they are willing to accept as they negotiate terms.

2. Preference multiples

This is the most visible part of the preference. A 1x liquidation preference means the investor gets back 100% of their original investment before anyone else gets paid (this is the most common in private markets). A 2x means they get double their initial investment. 3x—triple.

While 1x non-participating preferences have become standard in most early-stage deals, later-stage rounds or down rounds might include 2x or even 3x multiples as a way to de-risk the investment.

Why it matters: In a modest exit scenario, high multiples can consume a large chunk of the proceeds—leaving little for everyone else. This is the most common reason why entrepreneurs can sometimes walk away with nothing, even if they exit the company for nine or ten figures. Preference multiples can add up and raise the stakes for a big exit, so common shareholders still walk away with proceeds. 

3. Participation rights

Participation rights are a clause included in the initial term sheet provided by an investor, governing how the investor will participate in the proceeds upon an exit event. Participation rights can be simply broken down into two different types:

• Non-participating preferred shares require investors to choose between taking their liquidation preference or converting to common stock to participate in the upside.
• Participating preferred shares let investors "double dip" by taking their preference and participating in the remaining proceeds as if they were common shareholders.

Some participating preferred shares include a cap (e.g. 2x return), after which the investor must convert. This protects founders and common shareholders in high-value exits while still rewarding investors in low-to-mid outcomes.

A simple example of a liquidation preference 

Let’s say a company raises $10M from Series A investors on 1x participating preferred shares with a 2x cap. Years later, the company is acquired for $40M. And let’s assume the Series A investors own 25% of the company.

Here’s how the proceeds break down:

• First, the investors get their $10M back (1x preference).
• That leaves $30M in remaining proceeds.
• Now, they also get to participate pro-rata in that remaining $30M — in this case, 25% of $30M = $7.5M. That brings their total payout to $17.5M. Since that’s below their 2x cap ($20M), they’re entitled to the full amount.
• The remaining $22.5M goes to the common shareholders — founders, early employees, and early angels.

In a common but unfortunate example, let’s take a company that raised $30M across three stacked rounds and gets acquired for only $25M. In that case, common shareholders would walk away with nothing.

Key details to look out for in a term sheet

Cumulative dividends

Some preferred stock comes with cumulative dividends, meaning unpaid dividends accrue over time and must be paid out during a liquidity event. This is less common in early-stage deals, but more prevalent in growth or PE-style rounds. Founders should be cautious: over time, accrued dividends can quietly chip away at the exit pool.

Participation overhang

Participating preferred shares can discourage new investors. If too much of the future upside is already spoken for due to prior participation rights, new investors may hesitate to come in unless those terms are cleaned up. This "preference overhang" can stall a company's fundraising or lower its valuation.

Impact on employees

It’s important to remember that employee stock options convert into common shares. If the liquidation preferences eat up most of the proceeds, your team might walk away from a sale with nothing. That has major implications for retention and morale.

Structuring fair and strategic terms

Not all liquidation preferences are bad. In fact, they can be essential for getting deals done. But founders need to understand the implications and use them strategically.

• 1x non-participating is often considered founder-friendly and aligns incentives well.
• If investors ask for participation, push for a cap to limit the downside for common shareholders.
• When considering multiple funding rounds, try to avoid stacking where possible or negotiate pari passu treatment across rounds.
• Simulate outcomes using cap table modeling tools to see who gets what in different exit scenarios.

Remember: The terms you negotiate today can shape outcomes years down the line.

How Zest can help

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