Key Highlights
- In venture capital deals, liquidation preference determines the order in which investors and founders receive payouts. It ensures investors receive their initial investment before the common stock receives any proceeds from the liquidation event. There are 2 types: (a) non-participating and (b) participating.
- One type of liquidation preference is a non-participating liquidation preference. This preference allows investors to receive a predetermined payout before the company makes any distributions to common stockholders. However, it does not allow them to participate in additional payouts to common stockholders. Therefore, it is non-participating, as it does not receive an additional pro rata share of the common stock.
- The other type of liquidation preference is a participating liquidation preference. This version of the liquidation preference gives investors priority in receiving their payout first and allows them to participate in additional payouts to common stockholders. They get to double-dip.
Introduction: What is a liquidation preference?
In the world of startups, investment agreements with liquidation preferences are a critical component that safeguards investors’ interests. Here’s a sample venture capital financing term sheet. When investors fund startups, they acquire preferred stock, which grants them preferred rights in terms of equity and control. Among these privileges is the liquidation preference clause. This provision outlines the hierarchy of payouts to investors and common stockholders in scenarios such as company acquisitions or mergers. The clause guarantees that venture capital investors get their investment back before common stockholders receive any payments in the event of a liquidation, such as a sale or merger. This preference protects investors by prioritizing their capital return. It is a common feature that investors often negotiate in preferred stock agreements.
A liquidation preference allows preferred stockholders to receive payment before common stockholders.
It outlines the order of return to investors triggered by specific events, such as liquidation, dissolution, merger, acquisition, or sale of all or substantially all of its assets. The liquidation preference outlines who will receive payment first and the amount they will receive. For example, a liquidation preference could be an amount equal to the initial purchase price or a multiple of that amount. Assume that Sandy Bill Ventures invests $2 million in Hashbrown Inc. The liquidation preference could provide that Sandy Bill will receive its $2 million back before the holders of common stock receive anything. Therefore, if the company liquidates for $4 million, the investor will receive $2 million first, and then the common stockholders will share the remaining $2 million.
Furthermore, understanding the nuances of liquidation preferences is important for both investors and founders. For investors, it offers a layer of protection and assurance regarding potential exit strategies and returns on investment. On the other hand, for entrepreneurs seeking funding, understanding how liquidation preferences work can help structure deals that are attractive to investors while ensuring that founders receive a decent payout upon the sale of their startup.
There are 2 different types of liquidation preferences: participating and non-participating preferences. Each type carries distinct implications for how stockholders and investors distribute proceeds in various exit scenarios.
Understanding Participating Liquidation Preference
A participating liquidation preference is investor-favorable. This structure ensures that investors holding preferred stock receive payment first when a company is sold or exits. In other words, they have a preference for the liquidating event. In addition, if it is a participating preference, they also share or participate in the remaining proceeds with common shareholders. They get to double-dip in the payout.
In simple terms, investors with this type of liquidation preference enjoy the benefits of both worlds. They have downside protection since they recover their investment, even in adverse scenarios. They also have the opportunity to benefit from sharing in any remaining profits from the exit event.
How Participating Preferences Work
Let’s simplify how a fully participating liquidation preference works using an example. Picture a company with investors holding participating preferred stock. They invest $1 million and have a 1x fully participating preference, owning 20% of the company. If this company sells for $10 million, here’s what happens:
First, the investors recoup their initial investment. In this case, that would be $1 million. Next, we examine the remaining proceeds. That totals $9 million, which is the total sale minus the initial payout.
Since the investors hold a 20% stake, they receive additional proceeds after receiving their liquidation preference of $1 million. They participate in the remaining payout of $9 million with the common stockholders. Therefore, because they have a participating liquidation preference, they will also receive $1.8 million (20% of $9 million). This brings their total payout to $2.8 million. The company will distribute the remaining $7.2 million to the common shareholders.
Benefits to Investors
Participating preferences offer numerous benefits to investors. They include:
- Better Returns: Participation rights enable investors to earn more than their original investment, thereby maximizing their upside potential.
- Protection from Losses: This structure ensures that investors recover their initial investment first, which helps mitigate losses if things don’t go as planned.
- Stronger Deals: Having participation rights can make the investment offer more appealing to investors. This can lead to better terms when raising money. However, note that the current trend is for non-participating preferences according to The Entrepreneurs Report for Q2 2025.
How Does a Non-Participating Liquidation Preference Work?
A non-participating liquidation preference, unlike a participating one, only entitles the investor to the liquidation preference. And, they do not share in the amounts distributed to common stockholders. Investors must decide whether to exercise the liquidation preference or convert their preferred stock into common stock, thereby receiving a proportionate share of the proceeds. If the sale price of the startup is high enough, and they would receive more by converting to common stock, the investors will convert to common stock, give up their preference, and receive their pro rata share. For a non-participating preference, investors must evaluate the total sale price at the time of exit and choose the option that maximizes their returns.
Characteristics of Non-Participating Preferences
In investment terms, a non-participating liquidation preference allows investors to recover their original investment when a company is acquired for a modest price. However, in the case of a lucrative acquisition, it is more common for investors to convert their preferred shares into common shares instead.
The essence of non-participating preferences lies in maximizing returns depending on the sales scenario. Investors meticulously evaluate their options and select the alternative that promises the most favorable outcome.
Comparing Participating vs Non-Participating Preferences
The choice between participating and non-participating liquidation preferences is crucial for startups seeking funding and for investors. Each option affects how money is shared during a liquidity event.
It’s essential to understand how these options impact ownership and potential returns. Such understanding also aids in future funding rounds, particularly as you raise additional rounds of preferred stock and have multiple series of preferred stock.
Examples: Participating vs Non-Participating Outcomes
Let’s examine how participating and non-participating preferences function in a potential sale of the company. Assume that our startup is acquired for $50 million.
If the Series A Preferred Stock invested $10M, has a 2x participating liquidation preference, and owns 20% of the outstanding stock of all preferred and common stock, here’s how it will play out:
- The investors will first get their 2x liquidation preference, or $20M (i.e. 2 * $10M original investment).
- The company will distribute $30M between the common and preferred stockholders.
- Since the Series A holds 20% of all the stock, on a pro rata basis, the Series A will then participate in the distribution with the common stock and receive an additional $6M (i.e. $20% of $30M remaining payout). The participating aspect of the liquidation preference entitled the investor to double dip, receiving their liquidation preference (1st dip) and then sharing in the remaining payout with the common stock (2nd dip).
- Therefore, the Series A, which holds a 2x participating liquidation preference, will receive a total of $26 million.
If the Series A Preferred Stock invested $10M and holds a 2x non-participating liquidation preference and owns 20% of the outstanding stock of all preferred and common stock, here’s how it will play out:
- The investors must decide whether they will receive a bigger payout by remaining as preferred stockholders with a non-participating liquidation preference or by converting to common stock, thereby giving up their liquidation preference and joining in the payout on a pro rata basis with all common stockholders.
- If they took their 2x liquidation preference, they would get $20M.
- If they convert to common shares, holding 20% of the total company, they would receive $10M.
- Since their 2x liquidation preference gives them a higher payout, they would stay as preferred stock with the non-participating liquidation preference and take home $20M.
Another Example of Participating vs. Non-Participating
Let’s assume that the founders of Hashbrown Inc. held 3,000,000 shares of common stock that they paid for at incorporation at $0.001 per share (or a total of $3,000). Sandy Bill Ventures invests $2,000,000 to buy 2,000,000 shares of preferred stock (i.e., $1.00 per share). The percentage of ownership for the founders would be 60% and 40% for Sandy Hill Ventures. Sandy Hill Ventures has a nonparticipating liquidation preference at 1x of the investment amount (i.e., for the same amount that was invested)
Now, if Hashbrown Inc. were acquired for $10 million, the preferred stockholders would convert their preferred stock to common stock to participate in the gain. If the preferred stockholders did not convert, they would be entitled only to their preference of $2 million. By converting to common stock (assuming a 1:1 preferred stock to common stock conversion ratio), the investors would receive their pro rata share of the $10 million, along with all the other common stock. Therefore, Sandy Bill Ventures will now hold 40% of the common stock and be entitled to receive 40% of the $10 million, or $4 million. Clearly, it is an easy decision for Sandy Hill Ventures to convert and get a bigger bounty.
However, many venture capital investors now negotiate for a participating liquidation preference. Preferred stock with a participating liquidation preference will get its liquidation preference first and then have the opportunity to participate pro rata with the common stock. Assuming the $10 million acquisition of TechStartup, Inc., Sandy Hill Ventures would receive a $2 million liquidation preference, plus be entitled to participate in receiving their pro rata share of the remaining $8 million. The residual $8 million (after the preferred stock receives its $2 million preference) will be divided pro rata between the common stock and the preferred stock, as if the preferred stock had been converted to common stock. Therefore, with a participating liquidation preference, Sandy Bill Ventures now receives a distribution of $2 million (i.e., the preference) plus $3.2 million in participation proceeds (i.e., 40% of the remaining $8 million) for a total of $5.2 million.
What is the current trend of liquidation preferences in venture capital deals?
According to The Entrepreneurs Report for Q2 2025, published by Wilson Sonsini (on a personal note, I started my practice at this firm), the current trend as of Q2 2025 appears to be primarily for non-participating liquidation preferences. In 2020, non-participating liquidation preferences accounted for 88% of the deals, and by 2022, this had risen to 91%. As of the first half of 2025, they now account for 93% of the deals.
Conclusion
In conclusion, it is essential to understand the differences between participating and non-participating liquidation preferences when a startup raises venture capital. Especially if there are multiple series (e.g., Series A, Series B, Series C, etc.) of preferred stock, each with a liquidation preference, it is even more crucial that the founders keep track of these preferences to ensure they receive a decent payout upon acquisition or merger. The founders want to avoid really high multiples of participating liquidation preferences to preferred shareholders because they risk hitting an exit without being paid a reasonable amount because the venture capital investors took a huge share of the sale price.
