Published on
February 20, 2026
Liquidation Preferences in Preferred Stock Deals
How liquidation preferences (1x, participating, capped) shape exit payouts, conversion choices, waterfall order, and negotiation tactics for founders.
Liquidation preferences decide who gets paid first - and how much - when a company is sold, merged, or liquidated. They are critical for investors and founders to understand, as they directly impact payouts during an exit. Here's the key takeaway:
- Preferred stockholders get paid first: They receive their original investment (or a multiple of it) before common stockholders.
- Types of liquidation preferences:
- Non-participating: Investors choose between their preference amount or converting to common stock for a larger payout.
- Participating: Investors take their preference amount and a share of the remaining proceeds, which can significantly reduce payouts for founders.
- Capped participating: Similar to participating, but with a limit on the total payout.
- Impact on founders: In small or moderate exits, heavy preferences can leave founders and employees with little to no payout.
For founders, negotiating a 1x non-participating preference is generally the most favorable option. Understanding how these terms work and modeling potential exit scenarios can help protect equity and ensure fair outcomes.
The Liquidation Preference in VC: Downside Protection + Tricky Excel Formulas
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How Liquidation Preferences Work
Liquidation preferences are calculated using two main factors: the original issue price (OIP) - the price investors paid per share - and a multiple that determines their payout. For instance, if an investor puts in $5 million at $2.00 per share with a 1x preference, they’re entitled to $5 million before common shareholders see any proceeds. With a 2x multiple, they’d be entitled to $10 million first [5][7].
The payout process follows a "waterfall" structure. First, any outstanding debts and liabilities are paid. Next, preferred shareholders receive their liquidation preference based on seniority. Finally, any remaining funds go to common stockholders, including founders, employees, and option holders [5][2]. Let’s break down the key elements that shape this process.
Key Components of Liquidation Preferences
The liquidation multiple is a crucial factor that provides additional protection for investors. A 1x multiple ensures they get back their original investment, while a 2x multiple doubles their payout before common shareholders receive anything [5][6].
As of 2025, 1x non-participating preferences are the standard in healthy Series A rounds [5]. However, during the market downturn in 2022-2023, deals with higher multiples - above 1x - became more common. By 2023, 5.5% of deals included such terms, compared to just 2.3% in 2021 [2]. While higher multiples offer investors greater protection, they can significantly reduce the returns founders see in smaller or moderate exits.
Conversion Decisions for Investors
Once the payout is calculated, investors must decide how to maximize their return. Preferred stockholders have the right to convert their preferred shares into common stock, typically at a 1:1 ratio [1][7]. The choice boils down to which option offers a higher payout.
"Non-participating preferred shares always have a tipping point, or conversion threshold, beyond which the preferred shareholders will convert to common." - John Demeter, former Counsel at WilmerHale [8]
In non-participating structures, investors must choose between taking their liquidation preference or converting to common stock to claim their ownership percentage of the exit proceeds. If the exit value is high enough that their ownership stake exceeds their preference amount, they’ll convert. In contrast, participating structures allow investors to receive their preference amount plus a pro-rata share of the remaining proceeds - commonly referred to as "double-dipping." Conversion is only considered in these cases if there’s a cap on participation that limits their total return [5][1].
| Exit Value | Option A: Take 1x Preference | Option B: Convert to Common (25%) | Investor Decision |
|---|---|---|---|
| $10 Million | $5 Million | $2.5 Million | Take Preference |
| $20 Million | $5 Million | $5 Million | Indifferent |
| $40 Million | $5 Million | $10 Million | Convert to Common |
| $100 Million | $5 Million | $25 Million | Convert to Common |
Scenario: $5M investment for 25% ownership ($20M post-money valuation)
The table illustrates how a 1x non-participating preference works. Below $20 million, the investor benefits more by taking their $5 million preference. Once the exit value exceeds $20 million, converting to common stock becomes the better option, allowing them to capture greater upside. Understanding this conversion threshold is critical for evaluating exit scenarios and plays a key role in shaping both investor and founder strategies.
Types of Liquidation Preferences
Liquidation Preference Types Comparison: Impact on Investor and Founder Payouts
Understanding the different types of liquidation preferences is key to navigating how exit proceeds are distributed between investors and founders. These structures determine who gets paid, how much, and in what order. There are three primary types, each with distinct implications.
Non-Participating Liquidation Preferences
Non-participating preferences are considered the most favorable for founders and have become the standard in venture financing. Here’s how they work: investors must choose between taking their liquidation preference (often 1x their original investment) or converting their shares to common stock to claim their pro-rata share of the exit proceeds. They cannot do both [2][5].
This setup simplifies decision-making for investors. If the exit valuation is low, they take their preference amount. If it’s high enough that their ownership stake exceeds the preference, they convert to common stock to maximize their return.
By Q3 2024, 96% of venture deals included 1x non-participating preferences, solidifying this as the preferred structure for early-stage financing [4]. Additionally, 97% of non-participating shares globally carried a 1x multiple by the same period [4]. These numbers highlight why this structure is widely adopted - it strikes a balance between risk and reward.
Participating Liquidation Preferences
Participating preferences are less favorable for founders and employees. They allow investors to collect their liquidation preference first, and then participate in the remaining proceeds alongside common stockholders on a pro-rata basis [2][9]. This means investors essentially get two payouts, which can significantly reduce the amount left for founders.
"Your holdings may be dramatically lower in value than you think, after all this structure comes into play." - Micah Rosenbloom, Founder Collective [4]
For example, imagine an investor puts in $5 million for 25% ownership, and the company sells for $30 million. With participating preferred stock, the investor first takes their $5 million preference, leaving $25 million. They then claim 25% of the remaining amount - $6.25 million - for a total payout of $11.25 million. The remaining $18.75 million is split among common shareholders, significantly impacting founder earnings.
This structure is often used in high-risk investments or distressed deals where investors seek maximum protection. During the 2022–2023 market downturn, these terms became more common, appearing in 83% of 2023 term sheets, up from 71% in 2022 [2].
Capped Participating Liquidation Preferences
Capped participating preferences strike a balance between investor protection and founder equity. Here, investors receive their liquidation preference and a pro-rata share of the remaining proceeds, but only up to a predetermined cap - typically 2x or 3x their investment [2][5]. Once the cap is reached, investors must choose between sticking with the capped amount or converting to common stock if it yields a better return.
"Capped participation limits the VCs' upside while still protecting their downside." - Matthew Wilson, Allied Venture Partners [2]
For instance, if an investor contributes $10 million for 30% ownership with a 3x cap, they can receive up to $30 million. In a $100 million exit, they would convert to common stock to claim their full 30% ($30 million), rather than being limited by the cap. This structure ensures founders retain more equity in large exits while still providing downside protection for investors in smaller outcomes.
| Feature | Non-Participating | Participating | Capped Participating |
|---|---|---|---|
| Investor Payout | Higher of preference or pro-rata share | Preference plus pro-rata share | Preference plus pro-rata share up to a set limit (e.g., 3x) |
| Founder Dilution Risk | Low; investors take only one "bite" | High; reduces common shareholder proceeds | Moderate; protects founders in large exits |
| Typical Use Case | Standard for early-stage deals | High-risk or distressed deals | Balances risk and reward |
When negotiating, founders should aim for 1x non-participating preferences to align with the fair conversion principles. If participation rights are unavoidable, insist on a cap - preferably 2x or 3x - to protect upside potential in successful exits [2][5]. Using cap table software to model different payout scenarios can also provide clarity on how distributions will play out under various exit conditions.
Next, we’ll explore how liquidation preference multiples and stacking influence payout distributions across different investor classes and funding rounds.
Liquidation Preference Multiples and Stacks
Understanding Liquidation Multiples
Liquidation multiples play a key role in determining how exit proceeds are divided, specifically how much investors receive before common shareholders see any returns. These multiples are calculated based on the original issue price of the investment. For instance, a 1x multiple ensures investors recoup 100% of their original investment, while a 2x multiple guarantees them 200%.
Let’s break it down with an example: If an investor contributes $5 million with a 1x preference, they get their $5 million back before common shareholders receive anything. With a 2x preference, that payout doubles to $10 million. The higher the multiple, the more exit proceeds go to investors first, leaving less for founders and employees.
Currently, the 1x non-participating preference dominates the market. It appears in a staggering 99.6% of Seed deals and 97.2% of Series D deals [12]. However, in tougher market conditions, multiples above 1x are becoming more common, rising from 2.3% of deals in 2021 to 5.5% in 2023 [2]. Interestingly, in lucrative exits, investors often convert their preferred shares to common stock to benefit from the upside [2].
"Liquidation preference is not about extreme outcomes or billion-dollar exits. It matters most in the far more common scenarios where a company exits below its headline valuation."
– Farheen Shaikh, Sr. Content Marketer, EquityList [11]
Founders should approach any request for a multiple higher than 1x with caution. These terms can significantly drain exit proceeds and create a "preference overhang", which can make the company less appealing to future investors [2]. In many cases, accepting a lower valuation with a 1x non-participating preference is a smarter move than agreeing to a higher valuation paired with a 2x or participating preference [13]. Once the multiple is set, the next critical factor is the order in which payouts occur, which is where liquidation stacks come into play.
Liquidation Stacks: Seniority vs. Pari Passu
The payout order, or liquidation stack, becomes especially important when a company has raised multiple funding rounds. This stack determines which investors are paid first, shaping how proceeds are distributed - particularly in smaller exits.
Standard seniority follows a "last-in, first-out" approach. This means that the most recent investors, like Series C, are paid in full before earlier investors, such as Series B and Series A. While this setup protects later-stage investors, it increases the risk for earlier backers and founders in modest exits [10]. Notably, the use of senior liquidation preferences in post-Series A deals has risen sharply, from 29.6% in 2022 to 47.0% in 2023 [4].
On the other hand, pari passu, which translates to "equal footing", ensures that all preferred stockholders are treated equally. If there aren’t enough proceeds to cover all preferences, the funds are distributed proportionally based on each investor’s contribution [3]. This structure balances the risk and reward across all rounds, preventing later investors from completely wiping out early investors and founders in moderate exits.
| Seniority Type | Payout Order | Impact on Early Investors |
|---|---|---|
| Standard (Senior) | Last money in, first money out (D > C > B > A) | High risk of receiving $0 in modest exits |
| Pari Passu | All preferred rounds paid simultaneously pro-rata | Shared risk/reward across all rounds |
| Tiered | Groups of rounds paid in senior blocks | Hybrid protection for later "tiers" |
For founders, negotiating for pari passu treatment across funding rounds can help protect early investors and employees in moderate exits [2]. Using fractional CFO services or cap table modeling tools to simulate various exit scenarios - downside, moderate, and high-value - can offer valuable insights into when preferences convert to common stock and how distributions will unfold [2].
Impact of Liquidation Preferences on Founders and Exit Scenarios
Low and High Exit Scenarios
Liquidation preferences play a crucial role in determining payout outcomes, especially when comparing low-value and high-value exits. In low-value exits, founders often find their equity wiped out entirely due to these terms. On the other hand, in high-value exits, investors may opt to convert their shares to common stock if it results in a better payout than their fixed preference, making the liquidation preference less impactful in such cases [5].
However, even in seemingly successful exits, later-stage investors can face disappointment. A prime example is Instacart's IPO in September 2023. Despite the company going public, the IPO price was significantly below the valuation at which later investors entered, leaving many of them "underwater" [14].
Negotiating Favorable Terms
Founders should view liquidation preferences as negotiable elements of a deal. Often, accepting a slightly lower valuation with straightforward 1x non-participating terms can be more beneficial than chasing a higher valuation tied to complex or less favorable terms. As Matthew Wilson from Allied Venture Partners puts it:
"A clean deal at a fair valuation is almost always better than a messy deal at an inflated one." [2]
When investors propose participating preferences, founders should negotiate caps - typically 2x or 3x the investment amount - to limit total payouts and safeguard their upside in lucrative exit scenarios [2][4][5]. Additionally, founders should push for pari passu treatment across all funding rounds. This approach ensures equal treatment for all investors and prevents later-stage backers from claiming an outsized share of the exit proceeds [2][15][5].
Another effective strategy is leveraging competition. Securing multiple term sheets can provide the bargaining power needed to negotiate better terms. Running waterfall models for different exit scenarios - ranging from poor to exceptional outcomes - can help founders understand the financial impact of various structures [2][15]. Founders might also explore milestone-based conversion provisions, where participating preferences convert to non-participating once certain revenue or valuation goals are achieved [4].
Exit Scenario Comparisons
The table below highlights how different preference structures affect payouts for investors and founders. It uses a scenario where a $10 million investment secures 25% equity in a $50 million exit:
| Preference Type | Investor Payout | Founder/Common Payout | How It Works |
|---|---|---|---|
| 1x Non-Participating | $12.5M | $37.5M | Investor converts to common shares (25% of $50M) as it exceeds the $10M preference. |
| 1x Participating | $20.0M | $30.0M | Investor takes the $10M preference plus 25% of the remaining $40M. |
| 1x Participating (2x Cap) | $20.0M | $30.0M | Investor takes the preference and participation, capped at 2x the original investment. |
| 2x Non-Participating | $20.0M | $30.0M | Investor takes a 2x preference ($20M), which exceeds the conversion value. |
The 1x non-participating structure stands out, leaving an additional $7.5 million in the founders' hands. It’s no surprise that 96% of deals in Q3 2024 opted for this structure [4].
For growth-stage companies preparing for an exit, understanding these dynamics is essential. Firms like Phoenix Strategy Group specialize in financial modeling and M&A advisory, helping founders navigate these terms and secure more favorable outcomes.
Conclusion
Liquidation preferences play a key role in determining how proceeds are distributed during an exit, directly shaping the financial outcomes for both founders and investors. The difference between structures like a 1x non-participating preference and a 1x participating preference can lead to vastly different payouts, even in successful exits. That’s why it’s critical for founders to fully understand these terms before agreeing to a term sheet - it’s a safeguard for both their equity and that of their employees.
In Q3 2024, 96% of deals featured a 1x non-participating preference[4], a structure often seen as more favorable to founders. However, participating preferences and higher multiples are becoming more common, particularly in tougher funding climates. This shift highlights the careful balance founders and investors must achieve when negotiating terms.
"The negotiation, therefore, is about ensuring that while investors are protected from downside risk, founders are not unfairly stripped of their upside potential."[2]
The Trados case - where preferred stockholders claimed nearly all of the proceeds - serves as a stark reminder of why understanding these terms is so important[4].
To navigate these complexities, founders should model various exit scenarios, including downside, moderate (3-5x), and high-return (10x+) outcomes, to see how payout structures impact equity. It’s also wise to negotiate for pari passu treatment across funding rounds and introduce caps on participating preferences wherever possible.
For growth-stage companies facing these intricate funding agreements, Phoenix Strategy Group provides financial modeling and M&A advisory services to help protect your interests. By understanding liquidation preferences now, you can better safeguard your equity and negotiate terms that balance investor protections with fair outcomes for founders.
FAQs
What is a liquidation preference “waterfall”?
A liquidation preference "waterfall" explains how proceeds are divided during a liquidation event. It sets a clear order of payments, starting with creditors, followed by preferred shareholders, and finally common shareholders. This process ensures each group receives its allocated portion in a structured sequence.
When should preferred investors convert to common?
Preferred investors typically choose to convert their shares to common stock when the potential upside of doing so surpasses the benefits tied to their liquidation preference. This usually happens in high-growth exit situations, such as acquisitions or IPOs, where the company's valuation far exceeds the liquidation multiple.
How do liquidation stacks affect payouts across rounds?
Liquidation stacks dictate how payouts are divided during events like acquisitions or bankruptcies. Preferred stockholders usually take priority, receiving payments first according to their liquidation preferences. In cases where a company has issued multiple classes of preferred stock across various funding rounds, senior investors - those with higher-priority claims - are paid before others. This hierarchy can significantly reduce or even completely wipe out payouts for later-stage investors or common shareholders if the available liquidation funds are insufficient.
