Liquidation preferences

When a startup is sold, the money does not simply split by ownership percentage. Venture investors hold preferred stock. That stock usually carries a liquidation preference: the right to be paid a set amount before common stockholders receive anything. Founders and employees hold common stock. In a modest sale, the preference can decide whether they receive a meaningful payout or close to nothing.

This page is general information, not legal, tax or financial advice. The examples are hypothetical and simplified. The actual terms live in your company's certificate of incorporation, which a lawyer should read with you.

How a preference works

A liquidation preference has four moving parts:

1. The multiple. A 1x preference returns the original investment. A 2x preference returns twice the investment.
2. Participation. Non-participating preferred chooses either its preference or its share as converted to common. Participating preferred takes the preference and then shares in what is left.
3. A cap. Some participating preferred stops participating once it has received a set total, often expressed as a multiple of the investment.
4. Seniority. When there are several series, the charter says who is paid first or whether they share.

Accrued but unpaid dividends can add to the preference if the charter says they do. Most early stage charters in Silicon Valley use noncumulative dividends that are paid only if declared, so they rarely add to the amount. Check the dividend section anyway.

What triggers a preference

A preference applies on a liquidation, dissolution or winding up. It also applies on a deemed liquidation event, which the charter defines. The NVCA's model certificate of incorporation, available from the NVCA model legal documents page, treats a merger or a sale of all or substantially all assets as a deemed liquidation event. That means an acquisition, the most common exit for Peninsula startups, runs through the preference waterfall.

An IPO is different. Preferred stock normally converts to common when a company goes public, so preferences disappear in a qualifying IPO.

Worked waterfall: four sale prices

The numbers below are hypothetical. A Series A investor puts $10 million into a company for preferred stock that converts into 25 percent of the company. Founders, employees and other common holders own the other 75 percent. There is no debt and no other preferred stock. The table shows what the investor and the common holders receive under four different preference terms, at four sale prices.

Reading the table:

• At $8 million, every form gives the investor everything. The sale does not even cover the $10 million preference.
• At $20 million, a 2x preference takes the entire sale. The common holders get nothing even though they own 75 percent.
• With 1x non-participating terms, the investor converts once 25 percent of the sale is worth more than $10 million. That happens above $40 million.
• Uncapped participation keeps paying the investor more than its 25 percent at every price. In the $100 million sale the investor receives 32.5 percent of the proceeds.
• With a 3x cap, participation stops at $30 million. At $100 million the investor takes the capped $30 million because converting would pay only $25 million.

Several series: senior or pari passu

Most companies raise more than one priced round, so preferences stack. Suppose, hypothetically, a seed investor has a $2 million preference and a Series A investor has a $10 million preference. The company sells for $9 million.

In the pari passu case, the Series A has 10 of the 12 million dollars in total preferences, so it receives 10/12 of the $9 million. Neither structure helps the common holders here, because the sale does not cover the total preference. Seniority is mostly a fight among investors, but founders should know how it affects whether earlier backers will support a sale.

Preferences in a falling market

Preference terms tend to get tougher when money is scarce. A company raising at a lower price than its last round may face requests for a higher multiple, participation or seniority over earlier series. Each of those adds to the stack that must be paid before common stock sees a dollar. Our down rounds guide covers the anti-dilution and pay-to-play terms that often arrive in the same negotiation.

Preferences also explain why the common stock price used for employee options is lower than the price investors pay. A 409A appraiser values common stock after accounting for the preferred stock's right to be paid first. Our valuations guide explains how that works and why the two prices can differ by a wide margin.

What Palo Alto founders typically ask

Is 1x non-participating still the norm?

Founders and lawyers on the Peninsula generally treat it as the baseline for early rounds. Terms vary with market conditions and the company's leverage. Avoid relying on anyone's general claim about what is standard this quarter; ask your lawyer what they are seeing in current deals.

Should we accept a higher valuation with a 2x preference?

Model it first. A bigger headline valuation with a larger preference can leave founders worse off in every outcome except a large one. The waterfall table above is the quickest way to see the trade.

What is a management carve-out?

When a sale price falls below the total preference, a board may adopt a plan that sets aside part of the proceeds for employees so the team stays through the deal. It needs investor support because the money comes out of what preferred holders would otherwise receive.

Do SAFEs have a liquidation preference?

Before conversion, Y Combinator's post-money SAFE gives the holder the greater of its purchase amount or the as-converted proceeds in a sale. In a dissolution, YC's guide places the SAFE on par with standard non-participating preferred. See our SAFE guide.

Negotiating sensibly

1. Run the waterfall at five or six sale prices, including a disappointing one.
2. Trade carefully. Giving up participation for a slightly lower valuation can be worth it.
3. Watch new series. Each later round can add a senior preference above existing ones.
4. Read the deemed liquidation definition, especially for licensing deals or partial asset sales.
5. Use counsel who sees many deals. Our startup law firms guide lists firms with Palo Alto offices, such as Wilson Sonsini on Page Mill Road.

Frequently asked questions