Lisette Oosterveen, Bart Dreef, Joel Erwteman, Tim Carapiet-Petit.
When start-up founders set out to raise capital, attention often goes straight to the numbers and the valuation. Yet tucked away in most term sheets is an often overlooked or misunderstood clause – the liquidation preference.
Liquidation preference dictates the order and amount in which investors are repaid. This clause therefore determines to a large extent the value of an exit for the shareholders and should always be the focus of attention.
What is a liquidation preference?
The fundamental idea of corporate law is that shareholders are entitled to the economic value of a company (whether through a liquidation, distribution of dividends or the proceeds of a sale) in proportion to the amount that they contributed to the company. Yet shareholders can, and often will, agree on arrangements that deviate from this principle. This is the so-called liquidation preference, colloquially also known as the 'waterfall'.
The liquidation preference determines who gets paid first when a company is sold, merged or wound down. In mature companies, this preference is usually also applied to dividends, but that is often not relevant in the start-up phase. Including a liquidation preference makes sure that preferred shareholders (often investors) are preferred over holders of ordinary shares (often founders and employees). Liquidation preferences come in different forms, and understanding their terms is crucial.
Different types of liquidation preference
Liquidation preferences specify a metric that must be met by the preference shareholders before ordinary shareholders receive any proceeds. For start-up companies this is usually a money multiple (such as 1x or 2x) but there are also other metrics, such as a fixed annual percentage of the invested amount.
Liquidation preferences can be either participating or non-participating.
With non-participating preferred shares, an investor is only entitled to the agreed return. Once the preference is paid, the remaining proceeds are distributed to the other (ordinary) shareholders. Usually, it is agreed that if the return on investment that follows from the waterfall is lower than the return of the other shareholders, the preference shareholders may convert into ordinary shares and receive pro-rata returns.
With participating preference shares, investors also first receive their preferential proceeds. But in this case, they continue to share in the remaining proceeds alongside ordinary shareholders on a pro-rata basis after they have received the preferential proceeds.
Depending on the structure and exit value, preferred shares can therefore significantly reduce – sometimes even eliminate – the payout available to ordinary shareholders.
How Liquidation Preferences Work: A Detailed Example
Here is an example illustrating two investors who each have a 1x participating liquidation preference, but who have different seniority levels. You will see the various shareholders receive different returns as the exit value increases.
In our example Investor 1 invested €500,000 and Investor 2 invested €700,000. Furthermore, the preferred shares of Investor 1 are senior, meaning they are repaid first. As the exit value rises, Investor 1 initially recovers its full €500,000 before Investor 2 receives anything. Investor 2 only receives (part) of its investment once Investor 1 has recovered its full €500,000 investment.
After both investors have been fully repaid (which requires an exit value above € 1,200,000), the founders begin to receive their portion of the proceeds. In our example the investors were granted participating liquidation preference rights. Therefore, they continue to enjoy an additional pro-rata return on their shares.
The graph shows that once the preference shares participate in proceeds together with the ordinary shares, they do so at a slower pace as they represent a (much) smaller percentage of the share capital of the company. The graph also clearly shows that there is a point where the additional value of an exit for the investors is minimal, even if the payout for the founders keeps increasing. This may create a conflict of interest regarding the timing of any exit or other liquidity event.
Why investors push for it (but should watch out)
For investors, a liquidation preference serves as downside protection. Investors want to safeguard that if the company exits at a lower‑than‑expected valuation, they are paid out before ordinary shareholders. Given the power dynamic in investment transactions, where investors are typically better positioned to make demands, some form of liquidation preference is very often part of the deal terms of venture capital transactions.
But investors should be careful not to overplay their hand. An overly investor-friendly preference structure can have unintended consequences. When founders and employees realize that their equity may have little or no payout under realistic exit scenarios, motivation, retention, and hiring can suffer.
What founders should pay attention to
Preference shares are a common tool in the investor tool kit. But founders should carefully consider the economics of their company. An ill-balanced preference stack can become so heavy that ordinary shareholders receive nothing unless the exit valuation is exceptionally high (see our earlier blog Don't prefer – Arguments against stacking preferred rights).
The good news for founders is that liquidation preference terms are often negotiable. The minimum return (1x vs. 2x or higher), the question of whether the preference should be participating or non-participating and determining the maximum return for investors (a so-called preferred participation cap) are all matters that are part of the discussion that founders should have with their investors at an early stage.
Finding the right balance should be a communal goal for investors and founders alike. As noted, a balanced structure protects investors without making the economic outcome for founders unattainable. Getting there is essential for long-term alignment between the shareholders and, consequently, the performance of the company.
Conclusion
Liquidation preference is not a minor contractual detail – it is the mechanism that determines who ultimately benefits from the financial success of a company. A high valuation may look attractive on paper, but without understanding the liquidation waterfall, founders and employees risk celebrating numbers that will never translate into a payout. The liquidation preference can significantly reduce or even eliminate the proceedings for ordinary shareholders, especially in modest exits.
Before signing any term sheet, all parties should model realistic exit scenarios under the proposed preference structure and ask their lawyers and financial advisors to assist. Only by running the waterfall across different outcomes can they understand their true economic position and avoid being surprised at closing.
At Wintertaling we advise founders and investors alike on the legal structuring of their start-ups and funding rounds. Our team would be available to discuss further with you, no matter whether you are considering entering into a funding round, unsure about your situation or just wish to discuss scenarios.
