When startups begin exploring funding rounds, they often encounter complex terms in term sheets. One of the most crucial terms founders must understand is the liquidation preference. Whether you’re a founder negotiating your first round of funding or a seasoned entrepreneur, knowing the implications of liquidation preferences can make or break your financial outcomes in the event of a company sale or exit.

In this article, we’ll break down what liquidation preferences are, why they matter, and how to navigate them during negotiations.

What Is a Liquidation Preference?

At its core, a liquidation preference ensures that venture capital (VC) investors recover their investment (and potentially more) before common shareholders—such as founders and employees—receive any proceeds in a liquidation event. This “preference” grants VC investors priority when the company is sold, goes public, or faces bankruptcy.

In practice, liquidation preferences apply broadly to liquidation events, which include:

• The sale of the company (via stock or asset purchase).
• A merger or acquisition.
• A change in control.
• Bankruptcy or dissolution.

Preferred stock, the type of equity typically issued to VCs, comes with these rights. It stands above common stock in the capital stack, offering additional protection to investors while influencing how much founders and employees ultimately take home.

Types of Liquidation Preferences

Liquidation preferences come in three main forms, each with varying levels of investor benefit and founder impact:

Straight (Non-Participating) Preferred

• Overview: Investors receive the return of their initial investment (plus any accrued dividends, if applicable) before the remaining proceeds are distributed to common shareholders.
• Investor Choice: Investors can opt to convert their preferred shares into common shares to share ratably in the proceeds if it yields a higher return.
• Impact on Founders: This type is the most founder-friendly and is common in early-stage (Series A) funding rounds.

Example:

• If an investor puts $5 million into your startup with a straight liquidation preference and your company sells for $30 million:
  • The investor first recovers their $5 million.
  • The remaining $25 million is distributed among common shareholders.

Participating Preferred

• Overview: Known as “double-dip preferred,” this structure is the most favorable for investors. They recover their initial investment and also participate in the remaining proceeds as though they held common stock.
• Impact on Founders: Participating preferred can significantly reduce the founder’s share of proceeds, making it less desirable for startups.

Example:

• With a $5 million investment and a participating preference:
  • The investor receives $5 million off the top.
  • They also share in the remaining $25 million, taking an additional one-third (assuming they own one-third of the company).
  • Total investor payout: $13.33 million (almost half of the total $30 million sale proceeds).

Capped Participating Preferred

• Overview: This hybrid approach caps the total payout to preferred shareholders. Once investors reach the cap, they no longer participate in the remaining proceeds.
• Impact on Founders: This is a middle ground—investors get additional security, but their upside is limited.

Example:

• If the cap is 2X the investment:
  • On a $5 million investment, the investor’s maximum return is $10 million, regardless of their percentage ownership.

The Role of Multiples in Liquidation Preferences

In addition to the type of preference, founders must watch out for multiples attached to liquidation preferences. A multiple (e.g., 2X or 3X) means the investor is entitled to recover two or three times their initial investment before proceeds are shared with common shareholders.

Why This Matters:

• A 2X liquidation preference on a $5 million investment means the investor recoups $10 million before any remaining funds are distributed.
• Combined with participation rights, this can leave founders with very little in exit scenarios.

How to Approach Multiples:

• Negotiate for a 1X multiple wherever possible.
• Use financial models to understand how multiples impact different exit scenarios.

How to Negotiate Liquidation Preferences

Push for Straight Preferred

• Straight preferred terms are the most common and founder-friendly in early-stage funding rounds. Avoid participating preferred structures when possible.

Set Caps on Participation

• If participation is unavoidable, negotiate for a capped structure to limit the investor’s upside.

Evaluate Exit Scenarios

• Ask your VC to provide financial models showing how different liquidation preferences and multiples impact founder payouts across various exit values.

Consider the Long-Term Impact

• Early liquidation preference terms set a precedent for future funding rounds. Overly generous terms in your Series A can snowball into worse terms in later rounds.

Why Liquidation Preferences Matter

Understanding liquidation preferences is essential because they directly affect how much money founders, employees, and early shareholders receive during a liquidity event. Investors want protection for their capital, but founders must strike a balance to ensure fair outcomes for themselves and their teams.

For example:

• If your startup is sold for $40 million, and an investor with a 2X participating preferred has invested $5 million for one-third of the company:
  • The investor receives $10 million as their liquidation preference.
  • They also take one-third of the remaining $30 million ($10 million), leaving founders with just $20 million (50% of the proceeds despite owning two-thirds of the company).

Takeaways for Founders

1. Understand the Math:
   
   • Use spreadsheets or financial models to calculate different payout scenarios.
   • Ensure you’re clear on how much you and your team will receive under various exit conditions.
2. Beware of Multiples:
   
   • Push back against 2X or 3X multiples, as they can dramatically reduce founder payouts.
3. Negotiate Smartly:
   
   • Advocate for straight preferred liquidation preferences and avoid participating structures wherever possible.
4. Think Long-Term:
   
   • Remember that Series A terms often influence future rounds. Lay the groundwork for founder-friendly terms from the start.

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Liquidation preferences are a critical part of venture capital funding. Founders who understand and negotiate these terms effectively can ensure fair outcomes for themselves and their teams while maintaining strong relationships with investors.

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