Liquidation preference is a term that often sits quietly in a term sheet until the very end of a company’s journey, at which point it becomes the most important sentence in the contract. It dictates the order in which creditors and shareholders get paid in the event of a liquidation or sale of the company.
For a founder, it is essential to understand that “liquidation” does not just mean bankruptcy. In legal terms, selling your startup to a big tech company for fifty million dollars is also considered a liquidation event. It is the moment the assets of the company are converted into cash.
This clause answers a simple question. When the money hits the bank account, who gets to take their share first?
The Hierarchy of Payouts
#In the startup ecosystem, not all stock is created equal. Investors typically purchase “Preferred Stock,” while founders and employees hold “Common Stock.”
The hierarchy generally looks like this:
- Debt Holders: Banks and lenders get paid first.
- Preferred Stockholders: Investors get their capital back next.
- Common Stockholders: Founders and employees split whatever is left.
This means that as a founder, you are effectively last in line. Liquidation preference is the mechanism that ensures investors get their money back before you make a dime. It is a downside protection for them. If the company sells for less than the amount of capital raised, the investors might take every single dollar of the sale price, leaving the founders with zero.
The Multiple Matters
#The standard deal in early-stage venture capital is a “1x non-participating” liquidation preference. This means the investor has the right to get one times their investment back before anyone else.
However, in distressed situations or aggressive markets, you might see a “2x” or “3x” preference. If an investor puts in five million dollars with a 2x preference, they are guaranteed the first ten million dollars of the exit. If you sell the company for eight million dollars, the investor takes it all. You still own the company on paper, but that ownership is worth nothing in cash.
Participating versus Non-Participating
#The most dangerous nuance for a founder to watch for is the word “participating.”
Non-Participating Preferred: The investor has a choice. They can either take their liquidation preference (their money back) OR they can convert their shares to common stock and take their percentage share of the deal. They choose whichever pays more. This is fair.
Participating Preferred: This is often called “the double dip.” The investor gets their liquidation preference (money back) AND they get to keep their ownership percentage to share in the remaining proceeds. They get paid twice.
Strategic Implications
#Founders often focus entirely on the valuation of the company during negotiations. They want a high headline number to show the world. However, a high valuation coupled with a dirty liquidation preference structure is a trap.
It is often better to accept a lower valuation with clean, standard terms (1x non-participating). If you agree to a 2x participating preference to get a higher valuation, you are effectively mortgaging your future exit. You are raising the bar of how much you need to sell the company for just to break even.