Liquidation preference explained

A liquidation preference determines the order and the amount in which proceeds are distributed when a company is sold. It is the term with the largest effect on outcomes and the one most often waved through.

The standard case

A one times non-participating preference gives the investor a choice: take the money invested back, or convert into common shares and take the pro rata share. A rational investor takes whichever is larger, which means the preference only matters in weak outcomes.

Participating preferences

A participating preference pays the invested amount first and then shares in the remainder as well. In a sale at twice the last valuation, this can move a meaningful share of the proceeds away from founders and employees.

Multiples and stacking

Preferences above one times appear in difficult financing markets. Where several rounds carry preferences, the structure can be stacked, meaning later investors are paid before earlier ones, or pari passu, meaning all are paid in proportion.

• One times non-participating is the market standard in healthy rounds

• Participation and multiples shift value away from common shareholders

• Seniority decides who is paid first if proceeds are limited

• Convertibles carry their own terms until they convert

The practical test is simple. Model the exit at several values and state who receives what at each one. If that table has not been built, the terms have not been understood.