Liquidation Preferences: The Silent Equity Killer

Of all the terms in a term sheet, liquidation preference might be the most misunderstood—and the most consequential. It determines who gets paid, in what order, when your company is sold or liquidated. Getting it wrong can mean the difference between founders making millions and founders making nothing.

The Basics: What Is Liquidation Preference?

When a company is sold (or liquidated), the proceeds don't just get split according to ownership percentages. Instead, there's a "waterfall" that determines the order of payments:

1. Creditors (loans, outstanding bills)
2. Preferred stockholders (investors)
3. Common stockholders (founders, employees)

Liquidation preference refers to how much preferred stockholders get before common stockholders see anything.

The Standard: 1x Non-Participating

The most founder-friendly (and increasingly standard) liquidation preference is 1x non-participating.

Here's how it works:

• Investors get back 1x their investment OR convert to common stock and take their pro-rata share
• They choose whichever is higher
• They don't get both

Example:

Investor put in $2M for 20% of the company. Company sells for $15M.

• Option 1 (Take preference): Get $2M back
• Option 2 (Convert): Get 20% of $15M = $3M

Investor chooses to convert and gets $3M. Founders and employees split the remaining $12M according to their ownership.

The Aggressive: Participating Preferred

Participating preferred (sometimes called "double-dip") is much more investor-friendly.

Here's how it works:

• Investors get back 1x their investment AND their pro-rata share of what's left
• They get both

Same example with participating preferred:

Investor put in $2M for 20% of the company. Company sells for $15M.

• First: Investor gets $2M back (the preference)
• Remaining: $15M - $2M = $13M
• Then: Investor gets 20% of $13M = $2.6M
• Total to investor: $4.6M (vs. $3M with non-participating)

That extra $1.6M comes directly out of founder and employee pockets.

The Really Aggressive: Multiple Preferences

Some term sheets include 2x or even 3x liquidation preferences. This means investors get 2x or 3x their investment back before common stockholders see anything.

Example with 2x non-participating:

Investor put in $2M for 20%. Company sells for $8M.

• Investor gets 2x their investment = $4M
• Remaining for everyone else: $4M

Compare to 1x non-participating:

• Investor would convert and get 20% of $8M = $1.6M
• Remaining for everyone else: $6.4M

That 2x preference cost founders and employees $2.4M.

When Liquidation Preferences Really Hurt

Liquidation preferences have outsized impact in two scenarios:

1. Modest Exits

If you raise $5M with 1x participating preferred and sell for $15M, the math starts getting ugly. Investors might take $5M off the top plus their percentage of the remaining $10M.

2. Stacked Preferences

After multiple funding rounds, preferences can stack. Imagine:

• Seed: $1M at 1x
• Series A: $5M at 1x
• Series B: $15M at 1x

That's $21M in preferences. If the company sells for $30M, only $9M goes to common stockholders—even if they technically own 40% of the company.

What to Negotiate

1. Always push for non-participating. 1x non-participating is now market standard for seed and Series A. Don't accept participating preferred without a significant concession elsewhere.

2. Never accept above 1x at seed. A 2x preference at seed stage is a major red flag about how the investor will behave in future rounds.

3. Watch for seniority. Later investors sometimes want their preference to be "senior" to earlier investors. This can create misaligned incentives.

4. Consider capped participation. If an investor insists on participation, negotiate a cap (e.g., "participating up to 3x return, then converts to common").

The Founder's Perspective

When evaluating liquidation preferences, always model out different exit scenarios:

• What do I make if we sell for 2x the post-money valuation?
• What about 5x? 10x?
• At what exit price do I make more than the investors?

If the answers surprise you, that's a sign to negotiate harder or walk away.

The Bottom Line

Liquidation preferences are one of the most important economic terms in your term sheet. The key principles:

• 1x non-participating is standard—don't accept less without good reason
• Participating preferred is aggressive—pushback is expected and appropriate
• Multiple preferences (2x+) are rare and concerning—proceed with caution
• Model your exit scenarios—understand what you'll actually take home

Your equity is worth nothing if liquidation preferences eat it all. Negotiate accordingly.