The short answer
A liquidation preference is a term in preferred stock that lets investors get their money back (or a multiple of it) before common shareholders, such as founders and employees, receive anything when the company is sold or wound down. The most common founder-friendly version is 1x non-participating.
- Preferred investors are paid before common shareholders in a sale.
- 1x non-participating: the investor takes their money back or converts to common, whichever is worth more.
- Participating preferred takes its money back and also shares in what's left.
- The preference matters most in modest exits.
How it works
When you sell shares in a priced round, investors usually buy preferred stock. Its terms, set out in the company's charter (certificate of incorporation), typically include a liquidation preference. Three versions come up most:
- 1x non-participating: the investor gets back what they invested, or converts to common and takes their percentage, whichever is larger.
- Participating: the investor gets their money back and then also takes their percentage of the remainder.
- Multiples (2x, 3x): the investor gets a multiple of their money back first. Rare at early stages and expensive for founders.
Worked example (hypothetical)
An investor puts in $2M for 20%. The company is sold.
| Sale price | 1x non-participating | 1x participating |
|---|---|---|
| $5M | Investor takes $2M (better than 20% = $1M); common splits $3M | Investor takes $2M + 20% of $3M = $2.6M; common splits $2.4M |
| $30M | Investor converts: 20% = $6M; common splits $24M | Investor takes $2M + 20% of $28M = $7.6M; common splits $22.4M |
Questions to ask
- Is the preference 1x, or a multiple?
- Is it participating or non-participating? If participating, is there a cap?
- How do different series of preferred stock rank against each other?
Why it matters to a pre-seed founder
SAFEs and convertible notes aren't preferred stock yet, but the priced round they convert into will set a liquidation preference, and it will apply to those converted shares too. When you get a term sheet, read the preference line carefully: a participating preference or a multiple can quietly move millions in a mid-sized acquisition. NVCA publishes free model financing documents, including a model certificate of incorporation, that are a useful reference with your lawyer.
Frequently asked questions
What does 1x non-participating mean?
The investor can take back the amount they invested or convert to common stock and take their ownership share, whichever is worth more, but not both.
When does a liquidation preference matter?
Mostly in sales where the price is modest relative to the money raised. In large exits, non-participating investors usually convert to common.
Is participating preferred bad for founders?
It gives investors more of the proceeds in every exit, so founders usually push back on it or ask for a cap on participation.