The Truth About Liquidation Preference: Investor Safety Net Or Founder Pitfall?

An increasing number of companies and investors are now relying on the liquidation preference provision to finalize funding deals. Although this clause is more common among later-stage company deals, like Series B and beyond, startups may also offer them.

Liquidation preference is essentially a strategy that enables investors to offset some of the risk they take. Particularly if the company they’re investing in has a low valuation or operates in a highly volatile sector. Using this clause, they can ensure recovery of a part of their investment if the company fails.

Understanding Liquidation Preference

The liquidation preference clause awards investors the right to get back their investment on a priority basis. They can recover their capital ahead of the owners, employees, and common shareholders in case the company is liquidated.

Startups historically have high failure rates, with at least 20% closing within an initial 12 to 24 months. At this time, they have typically raised their seed funding round, which means that investors stand to lose that money. They are understandably wary of backing new companies that may not succeed.

Thus, investors may negotiate to include a liquidation preference clause in the investment agreement. This clause determines the order or priority in which investors get a payout if the company goes through liquidation. That is, if it is sold or goes bankrupt.

Investors holding preferred shares can receive a share of the returns before other stakeholders. They factor in the risk that the proceeds from the company sale are not adequate to repay all the existing shareholders in full. In that case, investors can get back at least a portion of the capital they invested.

Investors and company founders should examine this provision and agree to it cautiously. It can impact how exit returns are distributed, which is a safety net for investors and acts as insurance. From the founders’ point of view, it can influence their ability to attract investors and secure capital.

However, they also stand to gain nothing if the company is sold for a low valuation. This is why both parties negotiate the liquidation preference provision in detail. It prompts discussions about the risk of failure early on, so they can make fair risk allocations.

The liquidation preference clause commonly appears in structured private capital funding deals and transactions. These can be promissory notes, venture capital contracts, and hybrid debt instruments.

Laws Governing Liquidation Preference

You’ll find more information about liquidation preference in the NVCA Model Amended and Restated Certificate of Incorporation. Here’s what Hoeg’s Law states:

“In the event of any liquidation, dissolution, or winding up of the Company, the proceeds shall be paid as follows:

Alternative 1 (non‑participating Preferred Stock): First pay [one] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred (or, if greater, the amount that the Series A Preferred would receive on an as‑converted basis). The balance of any proceeds shall be distributed pro rata to holders of Common Stock.”

The liquidation preference clause also segregates the venture capitalist firm investing in the company from other shareholders. That’s because the law recognizes VC capital as part of the common shareholders’ category in the cap table.

Also note that the liquidation preference clause is only relevant when the company enters into a merger or acquisition deal. Or if it sells off its assets as part of a recapitalization deal or goes through a bankruptcy.

Of course, the liquidator factors in the company’s secured and unsecured loans before paying off investors. And that includes any stakeholders who hold shares with liquidation preference.

If the company goes public by issuing an Initial Public Offering (IPO), again, the clause is not valid. At this time, all existing shareholders automatically convert into common shareholders.

Let’s Check Out Some Statistics

The trend toward including the liquidation preference clause in term sheets caught on in a big way post the pandemic. Investors had a lot of gunpowder remaining by the third and fourth quarters of 2022 and the beginning of 2023.

This factor resulted in the capital markets tilting in favor of venture capitalists. Funding rounds began to include more participating preferred shares and cumulative dividends to attract investors. By Q1 2024, liquidation preferences of 1x or higher started appearing in 8% of all funding deals.

If you check the more recent figures, 94% transactions included 1x liquidation preference, while 95% deals were non-participating preferred rounds. This trend is increasing in Q2 2025, with 98% using 1x liquidation preference.

As noted earlier, liquidation preference provisions are more common in later-stage Series B rounds. Interestingly, in 2025, 100% deals have this clause. Of these, 78% are pari passu with other preferred, 19% senior, and 3% complex.

Let’s Try an Example

A venture capital firm invests $2M in a startup for $1M in preferred stock with liquidation preference. And another $1M in common stock. As a result, they now own 50% of the equity. Let’s also assume that the startup’s founders have also invested $1M and hold a 50% stake in common stock.

If the company is sold for $4M, the investors will receive $1M because of their preferred stock. They will receive another 50% of the remainder, which is $1.5M. The founders will also receive $1.5M.

As a result, investors walk away with $2.5M, while the founders are left with $1.5M. They must share this amount with other common shareholders (if any), employees, and other holders in the cap table.

However, if the company is sold for $2M, investors will claim $1M of their preferred stock. They can also claim another 50% equity and receive $50K, bringing the total to $1.5M. The founders will be left with just $50K.

At the same time, the liquidation preference does not award priority over other liens. For example, if the company goes bankrupt, liquidators sell its assets and first pay off senior creditors and junior creditors. After paying off bondholders, they cover liens on specific assets, such as mortgages.

Investors with liquidation preference receive payment out of the remaining proceeds.

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Structuring Liquidation Preference Clauses

You can structure the liquidation preference clause in different ways depending on the terms you’ve negotiated with investors. Here are some of the main options:

The Multiple

This structure is straightforward and simply reflects the multiple of the original investment amount. This can be one, two, or three times the capital invested. The most common structure is the 1x payout, in which investors can claim priority in getting back their capital.

A 2x or 3x liquidation preference is less common and enables investors to claim twice or three times their investment. That is, before any other shareholder in the lower priority stack can receive anything. To go with the earlier example, if the venture capitalist has invested $2M, they receive $2M back.

However, if the terms of investment included a 2x multiple, these investors would receive $2M from the company’s sale proceeds. And then another 50% of the remaining $2M, arriving at a total of $3M.

Non-Participating Liquidation Preference/Straight Preferred Stockholders

In the event of a company liquidation, investors with non-participating liquidation preference have two options. They can:

• Receive an amount equivalent to the multiple in the investment terms, as well as any unpaid dividends due to them.
• Convert their preferred shares into common equity and receive returns similar to those of the common shareholders.

If the company has been sold for substantial returns, investors can choose to convert. Thus, they can receive the per-share price for their stock. However, if they anticipate low returns, it would make more sense to exercise their liquidation preference rights.

At the same time, investors should also opt for conversion only if the exchange is 1:1 or higher. If the rate is less than 1:1, they may choose the second option.

Full Participating Liquidation Preference

Investors with full participating liquidation preference are also termed participating preferred, with no cap or full participating preferred. These participating preferred stockholders have two options. They can:

• Exercise their right to claim their capital amount back before the other shareholders receive anything.
• In addition, they can claim a percentage or pro rata of the remaining proceeds along with the other common shareholders.

This clause is less standard than non-participating liquidation preference and essentially enables investors to double-dip. They can claim shares out of the returns twice over.

Capped Participation

Capped participation allows investors with liquidation preference rights to receive their invested capital before the other shareholders. But with a cap. The investment agreement sets a limit on the amount they can receive without converting their preferred stock into common stock. They can:

Let’s try an example. A venture capitalist invests $1M with a 1x participating liquidation preference. They get a 50% ownership stake in the company at a $3M cap. This clause means that the VC can take a maximum of $3M without converting their stock into common stock.

Whatever proceeds from the company’s sale remain after paying off $3M is split between the other shareholders.

Are you looking for more information about what preferred shares are? Check out this video I have created explaining how to manage them.

Structuring the Liquidation Preference According to Seniority

As companies grow and raise further funding rounds, they add new investors to the cap table at every round. Each investor gets their rights and privileges; some may also have a liquidation preference, but with varying structures.

This is why companies must define the seniority structure and establish an order according to which investors receive payment. The seniority structure can be of three different types, such as:

• Standard: In this case, you’ll make liquidation preference payments to the investors in the latest funding rounds first. And then progress to the earliest investors. For instance, if you’ve raised a Series A round, these investors receive their capital before the seed investors. Lead and seed investors carry the risk of not receiving anything.
• Pari Passu: In this case, all the investors receive payouts from the company’s sale proceeds regardless of seniority. You’ll calculate the payouts pro rata according to the capital they have invested in the company.
• Tiered: In this case, you’ll structure the liquidation preference as a hybrid between the standard and pari passu formats. You’ll group the different funding rounds from Series C to Series E into tiers. Investors within each tier follow the pari passu model and receive pro rata capital shares.

Investor Safety Net or Founder Pitfall?

As the founder, you need to be cautious about giving away liquidation preference rights. Ensure that you understand the terms and conditions and be wary of dirty or toxic term sheets with predatory clauses. Seeking the advice of expert legal counsel is always advisable. Here’s what to look for:

• When agreeing to priority payouts, you’ll factor in the rights and privileges investors in further funding rounds may require.
• Think about how liquidation preference clauses can impact not just your ability to raise funding at present. But also in the future. For instance, you agree to offer a 3x multiple to a Series B investor. In that case, you might have to offer the same or a higher multiple to a Series C investor.
• Accepting terms like full participating liquidation preference allows investors to engage in double-dipping and claim more than a fair share.
  You should be wary of the risk of investors walking away with almost all the proceeds from the company’s sale.
• Early-stage investors could hesitate to offer capital to your startup if they anticipate you’ll award liquidation preference in the future. This move could impact the returns they can expect to earn since they will be pushed lower down on the seniority framework.
• Refrain from offering multiples higher than 1x non-participating liquidation preference. You’ll create a balance by attracting investors but also securing the rights of common shareholders. Most importantly, you’ll secure the returns you should be earning as the founder.

The Takeaway!

When you’re approaching investors for capital for your startup, offering liquidation preference can seem like a great strategy. Investors are likely to view the provision as a risk-mitigating measure and may agree to back your company.

However, be sure to weigh the pros and cons carefully and structure the clauses strategically to create an optimum balance. Ensure that you secure your ownership stake and the rights of existing investors when you secure capital in future funding rounds.

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