Liquidation Preferences

The Downside Protection Mechanism

A liquidation preference is a term that dictates who gets paid first and how much they get paid during a liquidity event (sale, merger, bankruptcy). It is designed to protect preferred investors (VCs) if the company sells for less than the post-money valuation of the last round.

1x Non-Participating (The Standard)

This is the cleanest and most standard term in early-stage venture. It gives the investor a choice upon exit:

1. Take their money back: Receive 1x their investment (before common shareholders get anything).
2. Convert to Common: Convert their preferred shares to common shares and take their pro-rata ownership percentage of the total exit.

They will choose whichever math yields the higher number. This creates a "conversion threshold" where the investor only participates in the upside if the exit is large enough.

Participating Preferred (Double Dipping)

Participating preferred is highly punitive to founders. In this structure, the investor does not have to choose. They get their 1x money back first, and then they "participate" by taking their pro-rata percentage of whatever money is left over.

Multiples and Caps

In distressed rounds, investors might demand a 2x or 3x liquidation preference (meaning they get $40M or $60M back before common sees a dime). If they have participating preferred, founders often negotiate a Cap (e.g., participation stops once the investor has achieved a 3x return).