What is a liquidation preference and what is a typical liquidation preference?
Takeaway: The liquidation preference is often the single most important economic term for an investor, guaranteeing they get their money back first in an exit; a "1x, non-participating" preference is the universal market standard and under normal circumstances anything more is a major red flag.
Of all the special rights that come with Preferred Stock, none is more important or more fundamental than the liquidation preference. The liquidation preference dictates the economic payout order in a "liquidation event," which includes not just a bankruptcy, but also, most importantly, a sale or acquisition of the company.
It is the key mechanism that provides downside protection for your venture capital investors. It ensures that if the company is sold for a modest amount, the investors get their money back before the founders and employees receive anything. Understanding how this preference works is critical to understanding the real economics of your financing deal.
How Does a Liquidation Preference Work?
The liquidation preference gives the holders of Preferred Stock the right to receive a certain amount of money from the sale proceeds before any proceeds are distributed to the holders of Common Stock.
The Multiplier (The "x"): The amount of the preference is expressed as a multiple of the original price the investor paid for their stock. The overwhelming industry standard is a 1x liquidation preference. This means the investor has the right to get back their original investment amount first. A 2x or 3x preference is extremely aggressive, founder-unfriendly, and a major red flag seen only in very difficult "down rounds" or other distressed situations.
The "Waterfall": Think of the proceeds from a sale as a waterfall. The money flows into the top "bucket," which is the 1x liquidation preference for the preferred stockholders. Only after that bucket is completely full does any money flow down to the next bucket, which belongs to the common stockholders.
The Critical Distinction: "Participating" vs. "Non-Participating"
Once the investor's 1x preference is paid, what happens next? This is governed by the second, equally important part of the term: whether the preference is "participating" or "non-participating."
Non-Participating (The Market Standard): This is the standard term. In this structure, the investor must make a choice. They can either (1) take their 1x liquidation preference and walk away, or (2) they can choose to convert their preferred stock into common stock and share in the proceeds "pro-rata" with all the other common stockholders. They will always choose the option that gives them a greater financial return. This is a fair structure.
Participating (The "Double Dip"): This is a much more aggressive, investor-favorable term. In this structure, the investor gets to "double-dip." They first get their 1x liquidation preference back, and then they also get to share pro-rata in the remaining proceeds alongside the common stockholders without converting their shares. This structure can dramatically reduce the payout to founders and employees in a modest exit and should be strongly resisted.
For any standard, competitive Series A financing, the market-standard term is a 1x, non-participating liquidation preference. It provides the fair downside protection that investors require, while still allowing the founders and employees to share in the upside of a successful outcome.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.