📖 Business
Liquidation Preferences
Liquidation preferences determine who gets paid first — and how much — when a company is sold, merged, or liquidated. This is the most economically consequential term in most venture deals, and it's the one founders most frequently misunderstand. The preference defines a "waterfall" — an ordered sequence of payouts that happens before common shareholders (founders, employees) see a dollar. In many exit scenarios, the difference between a 1x non-participating preference and a 1x participating preference is millions of dollars shifting from founders to investors.
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How It Works
Three types of liquidation preferences:
1x Non-participating (founder-friendly):
- VC gets their money back OR converts to common stock — whichever is more.
- Example: $10M invested, 50% ownership, $30M exit. VC chooses max($10M, 50% x $30M) = $15M. Founders get $15M.
- The investor only "double-dips" in one direction — they pick the better outcome.
1x Participating (investor-friendly):
- VC gets their money back AND shares in the remaining proceeds pro rata.
- Example: $10M invested, 50% ownership, $30M exit. VC gets $10M back + 50% of remaining $20M = $20M total. Founders get $10M.
- The participation costs founders $5M compared to non-participating.
Multiple participating (harsh):
- VC gets 2x or 3x their money back PLUS pro rata share of the rest.
- Example: $10M invested at 2x participating, 50% ownership, $30M exit. VC gets $20M back + 50% of remaining $10M = $25M. Founders get $5M.
- Rarely justified except in very risky or distressed deals.
Key modifiers:
- Participation cap — limits how much the participation can add (e.g., capped at 3x total return), then converts to common.
- Seniority — later-round investors may have preferences that pay out before earlier investors.
- Stacking — multiple rounds of preferences that all pay out in order before common shareholders get anything.