Imagine you’ve invested in a company, and now it’s being sold or its assets are being liquidated. A liquidation preference determines who gets paid first and how much they get before others receive anything. Think of it as a safety net for investors. If the sale price is lower than what they initially put in, this clause makes sure they get their money back before anyone else does.

There are two key parts to a liquidation preference: the preference itself and something called participation. The preference part means that, in a liquidation event, certain investors get paid a specified amount before others. So if you’re an early investor, you might be entitled to a 1× liquidation preference—meaning you get back exactly what you invested before others get paid.

Then, there’s the participation part, which comes into play after the initial preference is met. Depending on the terms, some investors not only get their money back but also share in any remaining proceeds, which adds an extra layer to their return.

Overall, liquidation preferences are there to protect investors, especially if things don’t go as planned and the company’s value doesn’t meet expectations. It’s a way for investors to manage risk while hoping for an eventual upside if the company does well.

I. Components of Liquidation Preference

Liquidation preference has two main parts that determine how money gets divided when a company is sold: (i) Actual Preference and (ii) Participation.

Actual Preference

This part, called the “actual preference,” is about giving certain investors—usually those who invested first or hold specific types of shares—priority to get paid before others when the company is sold. Think of it as a line where some investors get to go to the front and claim their share before anyone else.

For example, if investors hold what’s called “Series A Preferred” stock, they’re first in line to receive an agreed-upon amount—often the amount they originally invested—before common shareholders get anything. The reason for this setup is simple: these investors took an early risk by putting money into the company, and this priority treatment helps protect that risk.

An example of how this might be worded in an agreement is: “In the event of liquidation, Series A Preferred shareholders are entitled to receive their original investment back before common stockholders receive any payment.”

Participation

The Participation part of liquidation preference determines if certain investors can receive additional money beyond their initial preference. Once they’ve received their priority payout (the “actual preference”), some investors might also get to participate in any remaining proceeds. There are three main types of participation:

• No Participation. In this setup, investors receive only their initial preference amount and nothing more. For example, if someone invested $4 million with a 1× liquidation preference, they would receive just their $4 million back, even if there’s more money left after that. This type is sometimes called “nonparticipating preferred” stock.
• Full Participation. Here, investors get their initial preference amount and a share of any leftover proceeds. For example, if an investor has a 1× liquidation preference with full participation, they get back their initial $4 million, and then they also share in the remaining proceeds based on their ownership percentage, as though they held common stock. This allows them to benefit both from their priority payout and from any additional upside.
• Capped Participation. Capped participation lets investors receive their preference amount and a portion of the remaining proceeds, but only up to a specific limit or “cap.” For example, if an investor’s cap is set at 2.5× their original investment, and they invested $4 million, they can receive up to $10 million in total ($4 million preference plus up to $6 million more from participation). Once they reach this cap, they don’t receive any additional payout, regardless of how much more is available.

II. Conversion and Participation

In liquidation preferences, conversion allows investors with preferred shares to switch their shares to common stock under certain conditions. This option gives them flexibility, as they can choose to convert if it will result in a higher payout. The decision to convert usually depends on a conversion ratio, which specifies how many common shares an investor receives in exchange for each preferred share.

Let’s break it down with an example.

Imagine an investor owns preferred stock with a 1:1 conversion ratio, meaning each preferred share can be converted into one common share. If the company is being sold, the investor can either (a) stick with the liquidation preference and receive their original investment back first or (b) convert their preferred shares into common stock and receive a share of the total sale proceeds based on their ownership percentage.

Here’s a scenario to illustrate how conversion might work:

1. Example 1 “No Conversion Needed”. Suppose the investor put in $3 million and has a 1× liquidation preference. The company is being sold for $4 million. In this case, the investor would likely choose not to convert, as sticking with the 1× liquidation preference guarantees them $3 million back before anyone else is paid. Converting would only dilute their payout, so they opt to keep their preferred status.
2. Example 2 “Conversion for a Higher Payout”. Now, let’s say the company is sold for $10 million, and the investor has 25% ownership in preferred shares. With a 1× liquidation preference, they could take back their original $3 million, but converting their shares to common stock would give them 25% of the $10 million sale price, or $2.5 million. In this case, they might choose to keep their preferred stock for the guaranteed $3 million payout, rather than converting to common and receiving a lower amount.
3. Example 3 “High-Value Sale and Conversion Advantage”. Finally, imagine a big exit where the company is sold for $20 million. Now, if the investor has 25% of the company, converting to common stock would result in a $4 million payout (25% of $20 million). In this case, conversion is beneficial because they can receive more than the $3 million from sticking with the liquidation preference.

III. Examples of Participation Scenarios

Let’s go over four different scenarios that show how participation terms impact investor and common stockholder payouts in a company sale. We’ll use examples with different types of liquidation preferences: 1× nonparticipating, 2× nonparticipating, 1× fully participating, and 1× capped at a 3× multiple.

Assume:

• The investor originally invested $2 million, holding 40% of the company.
• The common stockholders own the remaining 60%.
• We’ll look at company sale values of $3 million, $10 million, $20 million, and $50 million.

Case 1. 1× Nonparticipating Preference

Terms: The investor has a 1× nonparticipating preference, meaning they can either take their initial $2 million investment back first or convert to common shares to receive 40% of the sale if it’s higher.

Sale Scenarios:

• $3 million sale: The investor takes their 1× preference, getting $2 million, leaving $1 million for common holders.
• $10 million sale: The investor could take their 1× preference ($2 million) or convert to receive 40% of $10 million ($4 million). They choose to convert, taking $4 million, while common stockholders get $6 million.
• $20 million sale: The investor converts to common to take 40% of $20 million, or $8 million. Common holders receive $12 million.
• $50 million sale: Again, the investor converts to common, receiving 40% of $50 million, or $20 million, with the remaining $30 million going to common holders.

Case 2: 2× Nonparticipating Preference

Terms: The investor has a 2× preference, which entitles them to twice their initial investment ($4 million) before common holders get anything.

Sale Scenarios:

• $3 million sale: The investor’s 2× preference entitles them to $4 million, but since the sale is only $3 million, they take the entire amount, leaving nothing for common holders.
• $10 million sale: The investor takes their 2× preference of $4 million, leaving $6 million for common holders.
• $20 million sale: The investor takes $4 million, with common holders receiving the remaining $16 million.
• $50 million sale: The investor converts to common to take 40% of $50 million ($20 million), which is higher than their $4 million preference. Common holders receive $30 million.

Case 3: 1× Fully Participating Preference

Terms: The investor has a 1× preference with full participation, meaning they first receive $2 million, and then share in the remaining proceeds based on their ownership.

Sale Scenarios:

• $3 million sale: The investor takes their $2 million preference, leaving $1 million for common holders.
• $10 million sale: The investor receives their $2 million preference and 40% of the remaining $8 million ($3.2 million), totaling $5.2 million, while common holders get $4.8 million.
• $20 million sale: The investor takes $2 million first, then 40% of the remaining $18 million ($7.2 million), for a total of $9.2 million, with common holders getting $10.8 million.
• $50 million sale: The investor receives $2 million, then 40% of the remaining $48 million ($19.2 million), totaling $21.2 million, with common holders getting $28.8 million. 

Case 4: 1× Preference with a 3× Cap

Terms: The investor has a 1× preference with participation capped at 3×, meaning they get back their $2 million investment and can participate up to a $6 million maximum payout.

Sale Scenarios:

• $3 million sale: The investor takes the $2 million preference, leaving $1 million for common holders.
• $10 million sale: The investor receives their $2 million preference and 40% of the remaining $8 million ($3.2 million), totaling $5.2 million. Since this is below the 3× cap, they keep it all, and common holders get $4.8 million.
• $20 million sale: The investor takes their $2 million preference and 40% of the remaining $18 million ($7.2 million), totaling $9.2 million. However, they’re capped at $6 million, so they stop there, and common holders receive the remaining $14 million.
• $50 million sale: Here, the investor also reaches their cap of $6 million, as their participation amount would otherwise exceed it. Common holders receive the remaining $44 million.

IV. Impact of Multiple Investment Rounds on Liquidation Preference

As a company raises more rounds of investment, liquidation preferences can become more complex. When multiple rounds (like Series A, B, and C) have different investors with varying priorities, there are two main ways these preferences can be structured: Stacked Preferences or Blended Preferences (also known as pari passu).

Stacked Preferences

With stacked preferences, each investment round has priority based on when it was made, with later rounds getting paid first. This structure is sometimes favored by newer investors who want assurance that they’ll recover their investment ahead of earlier rounds. Here’s how it might work in practice:

• Imagine a company has raised three rounds: Series A ($3 million), Series B ($7 million), and Series C ($10 million), for a total of $20 million in investments.
• If the company is sold for $15 million, Series C investors, having the latest round, would be paid back first. They receive their $10 million investment, leaving $5 million.
• Series B investors would then receive up to their $7 million investment from the remaining $5 million, but since that’s all that’s left, they only recover $5 million.
• Series A investors would receive nothing because the sale price doesn’t cover earlier investors’ stacked preferences.

Stacked preferences make each subsequent investment round riskier for previous investors, as they move further down the payout line if the company doesn’t achieve a high sale price.

Blended Preferences (Pari Passu)

In blended preferences, or pari passu structure, all rounds share the proceeds proportionately based on their investment amounts, without one round being prioritized over another. This approach spreads the risk more evenly among investors in different rounds.

• Using the same investment amounts as above, let’s say the company is again sold for $15 million.
• With blended preferences, the proceeds are distributed pro-rata. Here’s how it might work:
  • Series A, which contributed $3 million, would receive a proportionate share of the sale price: 15% of the $15 million, or $2.25 million.
  • Series B, which invested $7 million, would receive 35%, or $5.25 million.
  • Series C, with the highest investment of $10 million, would receive 50%, or $7.5 million.

In this scenario, all rounds of investors get some return, rather than later investors getting prioritized. Blended preferences are often seen as fairer when the company has a diverse set of investors who all took risks at different stages.

The choice between stacked and blended preferences often depends on the investors’ bargaining power and the company’s needs. Later-stage investors, like Series C, may prefer stacked preferences to maximize recovery if the exit is small. Meanwhile, blended preferences are more equitable and can appeal to early investors by giving everyone a fair share of proceeds, regardless of the investment sequence.

V. Negotiating Liquidation Preferences

When setting up liquidation preferences, companies and investors must find a balance that protects investors while also keeping employees and management motivated. Liquidation preferences should ideally provide security for investors without overly limiting the potential rewards for the team running the company.

Investors typically want liquidation preferences to secure their investment, especially in the early stages when the company’s future is uncertain. However, setting high or complex preferences can limit the amount left over for employees and management, who are usually holding common stock or options. If team members feel they won’t see significant rewards unless the company has a very high sale price, their motivation to drive the company forward may decrease.

For example:

• Suppose an early-stage company raised $1 million in a seed round with a 2× liquidation preference, guaranteeing the seed investor $2 million in a sale before any proceeds reach common shareholders.
• If the company later sells for $3 million, the investor would take $2 million, leaving only $1 million for all common shareholders, including employees and management.
• In this scenario, the small remaining payout may discourage employees, as they see limited upside unless the company achieves a very high exit.

Finding a balance often means negotiating preferences that protect investors without excessively reducing potential returns for the team. For instance, a 1× preference, rather than 2× or 3×, can offer investors downside protection while still allowing meaningful upside for common shareholders in smaller exits.

Best Practice: Keeping Preferences Simple and Lightweight in Early Rounds

In early rounds, it’s generally advisable to use straightforward and low-level liquidation preferences, such as a 1× nonparticipating preference. This simple structure ensures that investors get their initial investment back but doesn’t add layers of complexity or significantly impact the returns available to employees and management.

For example:

• A company raises $500,000 in its seed round, with a 1× nonparticipating liquidation preference. If the company is sold for $2 million, the investor would take back their $500,000 first, leaving $1.5 million to be shared among common shareholders, which includes employees and founders.
• This simple approach gives early employees and management a strong incentive, as they can see a meaningful return in even moderately successful exits.

VI. Defining a Liquidation Event

A liquidation event is any situation where a company undergoes a significant change in ownership or control, triggering the payout rights defined in the liquidation preference terms. Liquidation events often include mergers, acquisitions, and changes in control, but they can also cover situations like the sale of all or most of the company’s assets. These events are essential to define in investment agreements because they determine when and how investors receive their payouts.

Types of Liquidation Events

1. Merger. When a company combines with another entity to form a new organization. For example, if Company A merges with Company B, creating a new merged entity, it can trigger a liquidation event for shareholders.
2. Acquisition. When one company buys out another, either through a purchase of shares or assets. For instance, if Company X acquires all shares of Company Y, this acquisition is a liquidation event for Company Y’s shareholders.
3. Change of Control. When there’s a significant shift in who holds controlling interest or voting power within the company. This could be through a sale of majority shares or a voting power transfer. For example, if a new investor acquires 70% of the voting shares, it may be classified as a liquidation event, allowing other investors to receive their payouts.
4. Sale of Major Assets. If a company sells off most of its assets or business units, this can also trigger a liquidation event. For example, if a tech company sells all its intellectual property and core assets, this sale could be treated as a liquidation event.

Standard Language for Defining a Liquidation Event

To ensure clarity, investment agreements often include precise language to define what qualifies as a liquidation event. Here’s an example of standard language:

“Liquidation Event. A liquidation event includes (a) any merger or consolidation of the Company with another entity in which the Company’s existing shareholders do not retain a majority of the voting shares in the surviving entity; (b) the sale, lease, or transfer of all or substantially all of the Company’s assets; (c) the sale or transfer of more than 50% of the Company’s voting stock to a single entity or group acting together; or (d) any other transaction in which the Company’s shareholders receive cash, stock, or other securities in exchange for their shares.”