Deal Terms
What is a liquidation preference?
Quick Answer
A liquidation preference gives preferred shareholders (investors) the right to receive their investment back before common shareholders in an exit. The standard is 1x non-participating, meaning investors get back their investment amount or convert to common stock — whichever is higher.
Detailed Answer
Liquidation preference determines payout order in an exit event (acquisition, IPO, or dissolution). It's one of the most important economic terms in a VC deal.
Types: - **1x Non-Participating** (Standard/Founder-Friendly) — Investors choose: get their money back OR convert to common stock and share proportionally. They pick whichever is higher. - **1x Participating** (Investor-Friendly) — Investors get their money back AND share in remaining proceeds proportionally. Sometimes capped at 2-3x. - **2x+ Preference** (Aggressive) — Investors get 2x (or more) their investment before anyone else. Rare and signals a desperate fundraise.
Example with 1x non-participating: - Investor puts in $5M for 20% of a company - Company sells for $50M - Option A: Take $5M preference = $5M - Option B: Convert to 20% of $50M = $10M - Investor chooses Option B ($10M)
Same scenario, company sells for $15M: - Option A: Take $5M preference = $5M - Option B: Convert to 20% of $15M = $3M - Investor takes preference ($5M), founders get $10M
Founders should strongly resist participating preferences and anything above 1x. These terms significantly reduce founder proceeds in moderate exits.
Related Questions
What is a SAFE (Simple Agreement for Future Equity)?
A SAFE is an investment contract created by Y Combinator where an investor provides capital to a startup in exchange for the right to receive equity in a future priced round, with terms like a valuation cap and/or discount rate.
What is a term sheet?
A term sheet is a non-binding document that outlines the key terms and conditions of a proposed investment, including valuation, investment amount, board seats, liquidation preferences, and protective provisions.
What is a convertible note?
A convertible note is a short-term debt instrument that converts into equity at the next priced round, typically with a valuation cap, discount rate, interest rate (2-8%), and maturity date (12-24 months).
What is anti-dilution protection?
Anti-dilution protection adjusts an investor's conversion price downward if the company raises a future round at a lower valuation (down round). The standard type is broad-based weighted average, which partially protects investors while limiting founder dilution.
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