In venture financings — equity raises such as Seed rounds, Series A financings, and later rounds — a common negotiation point is the liquidation preference attached to the preferred stock issued in that series.
Despite the name, a liquidation preference does not apply only in a bankruptcy or dissolution scenario. While preferred shareholders generally sit behind creditors in an actual liquidation, liquidation preferences are most often triggered in a sale of the company.
In those situations, the sale proceeds are distributed according to a waterfall, under which preferred shareholders receive distributions before holders of common stock.
The Purpose of a Liquidation Preference
The liquidation preference is intended to provide investors with a degree of downside protection. It ensures that, before common shareholders participate in the proceeds of a sale, investors have the opportunity to recover some or all of the capital they invested in the company.
The exact structure of the liquidation preference can materially affect how sale proceeds are distributed among investors, founders, and employees.
1x Non-Participating Liquidation Preference (Market Standard)
The most common structure in venture financings is a 1x non-participating liquidation preference.
Under this structure, investors are entitled to receive up to the amount of their investment before any proceeds are distributed to common stockholders.
If the company is sold for less than the total invested capital, the preferred holders may receive the entire sale proceeds up to the amount of their preference.
If the company is sold for more than the invested capital, the investors typically have the option to convert their preferred shares into common stock and participate in the sale proceeds on a pro rata basis.
In practice, investors choose whichever option produces the greater return: the liquidation preference or their ownership share of the sale proceeds.
Participating Liquidation Preferences
By contrast, a participating liquidation preference allows investors to receive both their liquidation preference and a share of the remaining proceeds.
Under this structure, investors first recover their investment and then continue to participate alongside common shareholders in the remaining proceeds. Because the investor receives both the preference and participation in the upside, this structure is sometimes referred to as “double dipping.”
Example
Assume an investor invests $1 million in exchange for 20% ownership of a company that later sells for $10 million.
Under a non-participating structure, the investor would convert their preferred shares to common stock and receive $2 million, representing their 20% share of the sale proceeds.
Under a 1x participating liquidation preference, the investor would first receive their $1 million preference, leaving $9 million in remaining proceeds. The investor would then participate in those remaining proceeds on an as-converted basis, receiving 20% of $9 million, or $1.8 million, for a total payout of $2.8 million.
Why It Matters
These and other preferred stock terms are typically negotiated at the term sheet stage, before the definitive financing documents are drafted.
While liquidation preferences may appear to be a term that only matters in downside scenarios, they can significantly affect how proceeds are distributed in a sale of the company. The preference itself serves as a tool to attract capital and protect investors, but more aggressive structures — such as participating preferences — can begin to reduce the portion of exit proceeds that ultimately reaches founders and holders of common stock.
For founders, understanding how liquidation preferences work — and how they interact with valuation and ownership — is an important part of negotiating venture financing terms.