Liquidation preference is a contractual right that gives certain investors (typically venture capitalists) priority to receive their investment back before other shareholders when a company is sold, liquidated, or wound up.
A liquidation preference is essentially a safety net for investors that ensures they get their money back first if things don't go to plan.
It's written into the investment agreement and specifies exactly how much an investor must receive before anyone else gets paid.
When your company experiences a "liquidation event" (like being sold or shut down), investors with liquidation preferences get paid first from the proceeds.
Only after they've received their guaranteed amount do other shareholders, including founders, receive anything from what's left over.
The most common types are non-participating (investors choose between their preference amount or their ownership percentage) and participating (investors get both their preference amount plus their share of remaining proceeds).
There are also multiple liquidation preferences, where investors get back multiples of their original investment.
Liquidation preferences become crucial during acquisitions, mergers, or company closures where the sale price is relatively low compared to the total investment raised.
In successful exits with high valuations, they often become irrelevant as the ownership percentage yields more value.
These preferences can significantly dilute founder returns, especially in modest exits.
If your company sells for less than expected, founders might receive little or nothing after investors exercise their liquidation preferences, even if they own substantial equity on paper.
Focus on keeping preferences as low as possible (ideally 1x non-participating), limiting participation rights, and ensuring preferences don't stack unfairly across multiple funding rounds.
Understanding how different scenarios affect your potential returns is essential before agreeing to terms.
Investors use liquidation preferences to protect their downside risk whilst still participating in upside potential.
Since they're typically investing large sums in risky early-stage companies, these preferences provide some security that they'll recover their investment even if the company doesn't achieve the explosive growth everyone hopes for.
