Liquidation preferences – breaking down the payout dynamics

read time: 6 mins
14.01.25

In the world of venture capital, liquidation preferences are one of the most critical terms for both investors and founders. They dictate how proceeds from a sale, liquidation, or winding-up of the company are distributed among shareholders. 

While they are designed to protect investors by guaranteeing a minimum return, their structure can significantly impact the amount founders and other shareholders ultimately receive.

This article explores the mechanics of liquidation preferences, the different types commonly seen in venture capital term sheets, and the implications for all parties. As part of our "Anatomy of a term sheet" series, we aim to demystify these terms and provide practical insights into how they operate in real-world deals.

What is a liquidation preference?

A liquidation preference determines how proceeds are distributed to shareholders during a liquidation event, which can include:

  • The sale of the company, either in full or substantially all its assets.
  • A winding-up or liquidation.
  • Certain other "deemed liquidation events," such as a merger or acquisition.

Preference shareholders typically get paid before ordinary shareholders. The mechanics of liquidation preferences are defined by:

  • Preference amount: the amount preference shareholders are entitled to before proceeds are shared with ordinary shareholders. This is often equal to the original investment amount but can include a multiple (e.g., 1x, 1.5x, or 2x the investment).
  • Participation rights: whether preference shareholders receive only their preference amount or also share in the remaining proceeds with ordinary shareholders.

Types of liquidation preferences

Non-participating liquidation preference

  • In this structure, preference shareholders receive their liquidation preference amount or their pro-rata share of proceeds (if they convert to ordinary shares)—whichever is higher.
  • This approach balances investor protection with fair treatment of founders and ordinary shareholders at higher valuations.

Example:

  • A VC invests £5 million in a company at a £20 million post-money valuation, with a 1x non-participating liquidation preference.
  • If the company sells for £15 million, the VC takes their preference amount (£5 million), and the remaining £10 million goes to ordinary shareholders.
  • If the company sells for £50 million, the VC converts their shares to ordinary shares, taking 25% of the proceeds (£12.5 million). 

Participating liquidation preference

  • Preference shareholders receive their liquidation preference amount and share in the remaining proceeds with ordinary shareholders, often referred to as a “double dip.”
  • This structure is more favourable to investors and can significantly reduce payouts to founders and ordinary shareholders.

Example

  • Using the same £5 million investment, with a 1x participating liquidation preference, if the company sells for £15 million, the VC receives their £5 million plus 25% of the remaining £10 million (£2.5 million), for a total of £7.5 million. 

Capped participating liquidation preference

  • To balance investor returns and founder equity, a cap (e.g., 2x the original investment) is sometimes applied to participating preferences.
  • Once the cap is reached, the investor converts to ordinary shares and participates pro-rata with other shareholders.

Example:

  • With a 1x participating liquidation preference capped at 2x, if the company sells for £20 million, the VC receives their preference amount (£5 million) plus 25% of the remaining £15 million (£3.75 million). Since this totals £8.75 million, not exceeding the 2x cap (£10 million), the cap does not apply.
  • If the company sells for £40 million, the VC converts to ordinary shares, taking their 25% pro-rata share (£10 million). 

Market practice and trends

Liquidation preferences are standard in venture capital deals, but the specific terms vary depending on the stage of the company, market conditions, and investor negotiation power.

  • 1x non-participating preferences are considered market standard in founder-friendly environments, particularly for early-stage investments.
  • Participating preferences are more common in later-stage investments or deals involving higher-risk profiles.
  • Capped participation is increasingly seen as a compromise to balance interests between investors and founders.

Founders should carefully review the BVCA Model Documents, which provide standard templates for preference share structures commonly used in UK deals.

Why liquidation preferences matter

Liquidation preferences directly impact the financial outcomes for all shareholders during an exit. For founders, understanding their implications is crucial to assessing the true cost of raising capital.

Impact of multiple rounds

In companies with multiple funding rounds, liquidation preferences can stack, creating a liquidation preference stack. This means that investors in later rounds (Series B, C, etc.) may have their preferences satisfied first, leaving less for early-stage investors and founders.

Example:

  •  A company raises £20 million across three rounds:
    • Series A: £5 million with a 1x preference.
    • Series B: £7 million with a 1.5x preference.
    • Series C: £8 million with a 2x preference.
  • In a sale for £30 million, the total payout to investors is £32 million, exceeding the sale proceeds. This leaves nothing for ordinary shareholders unless preferences are waived or restructured. 

Negotiation strategies

For founders, negotiating liquidation preferences is about balancing investor protections with preserving long-term equity incentives. Common strategies include:

  • Capping participation: introducing a cap (e.g., 2x the investment) to limit disproportionate investor returns.
  • Avoiding stacking preferences: structuring new preferences to rank equally (pari passu) with earlier rounds rather than senior to them.
  • Modelling scenarios: running financial models to understand how preferences will affect payouts under different exit scenarios.

Analysis: founders’ perspective vs investors’ perspective 

 

Founders’ perspective

Investors’ perspective

Motivations

Founders aim to retain as much equity as possible and maximise their share of exit proceeds. They seek terms that incentivise long-term growth without overburdening the cap table with investor-favourable preferences. Investors use liquidation preferences to protect their downside risk, ensuring they recoup their investment before ordinary shareholders receive proceeds. This is particularly critical for high-risk, early-stage investments.

Preferred position

  • Non-participating liquidation preferences.
  • Caps on participating preferences (if unavoidable).
  • Pari passu ranking for multiple investment rounds.
  • 1.5x to 2x participating preferences for later-stage investments.
  • Uncapped participation for high-risk deals or where returns are uncertain.
  • Senior ranking for later rounds to protect new capital.

Risks

Aggressive preferences, especially stacked or uncapped participation, can leave founders with little to no payout in low-to-mid-value exits. Overly aggressive preferences may deter founders, reducing their motivation to grow the business, and complicate future fundraising efforts.

Where they align

Both parties benefit from a balanced structure that aligns incentives and attracts future investment. Non-participating preferences or capped participation can strike a fair balance, ensuring investors are protected while founders retain motivation to build long-term value. 

In summary

Liquidation preferences are a vital term in any venture capital deal, shaping how exit proceeds are distributed and protecting investors’ returns. Founders must understand their mechanics and negotiate terms that balance protection with equity alignment. By carefully modelling outcomes and aligning interests, founders and investors can create structures that incentivise success for all parties.

Read the next article in our ‘Anatomy of a term sheet’ series, where we’ll examine the mechanics of share options, their impact on the cap table, and the considerations for both founders and investors. 

If you're navigating the complexities of venture capital term sheets or preparing your business for investment, our experienced team is here to help. Get in touch to discuss how we can support you in securing the right deal for your business.

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