Liquidation Preferences: How They Affect Payouts in an Exit

Liquidation preferences define who gets paid first and how much when your company is sold or wound down. While they may seem like boilerplate, these clauses can dramatically reshape exit outcomes for founders, investors, and employees. This article breaks down what liquidation preferences are, how they’re structured, and what to watch out for before signing a term sheet.

TL;DR

• Liquidation preferences determine who gets paid first in an exit and how much.
• Seniority can be stacked (Series C → B → A → Common) or pari passu (equal priority).
• Higher preference multiples (e.g. 2x) increase investor payouts before others see returns.
• Non-participating = 1x or equity share (not both); most common in early-stage deals.
• Participating gives both 1x and equity share; capped participation limits total return.
• Founders should always model exit outcomes to understand dilution and alignment.

Understanding Liquidation Preferences

When raising venture capital, liquidation preferences are one of the most impactful terms in a term sheet. While they’re often viewed as boilerplate, they can dramatically affect who gets what in an exit and how aligned your cap table remains as the company grows.

In simple terms, a liquidation preference dictates how proceeds from a sale or wind-down are distributed between investors (usually holders of preferred stock) and common shareholders (typically founders and employees).

The Building Blocks of Liquidation Preferences

Seniority in Liquidation Preferences

Stacked Seniority

Series C → Series B → Series A → Common (Most senior gets paid first)

Seniority defines the order in which different classes of shareholders are paid in a liquidity event, such as an acquisition or liquidation. In a stacked structure, later investors (e.g., Series C) are paid first, followed by earlier rounds like Series B and Series A, and finally common shareholders. This structure gives stronger downside protection to newer investors. If the total exit value is less than the sum of the liquidation preferences, junior classes, especially founders and employees holding common stock, may receive little or nothing.

Pari Passu

Series A + Series B + Series C → Common (All preferred share classes treated equally)

In a pari passu structure, all preferred shareholders, regardless of funding round, share liquidation proceeds equally in priority, based on the proportion of their investment. This structure removes the hierarchy among preferred rounds and simplifies payout modeling. It can be seen as a fairer or founder-friendly model, though it offers less protection for late-stage investors.

Tiered Seniority

(Tier 1: Series C, Series D) → (Tier 2: Series A, Series B) → Common (Stacked between tiers, pari passu within each tier)

A tiered structure groups investors into seniority blocks. For example, later-stage rounds like Series C and D may be grouped as Tier 1, while early-stage rounds like Series A and B make up Tier 2. Within each tier, proceeds are distributed pari passu. However, Tier 1 is senior to Tier 2, so they are paid first in full before any remaining proceeds flow to the next tier. This hybrid approach balances investor protection with simplicity.

Custom Seniority

Series A → Series C → Series B → Common (Seniority defined arbitrarily by agreement)

In a custom seniority structure, the payout order is uniquely negotiated between investors and the company. For example, early investors (Series A) may retain seniority over later rounds, or Series C might be subordinated to Series B. These structures are uncommon and require explicit detailing in the investment agreements. They are typically the result of specific strategic or negotiating dynamics.

Preference Multiples

Model Structure: 
1x = $5M back on $5M invested
2x = $10M back on $5M invested

A preference multiple determines how much an investor receives before others in a liquidity event. A 1x multiple means the investor gets back their original investment. A 2x multiple means they receive twice that amount before proceeds are shared with common shareholders.

For example, a $5M investment at 2x yields a $10M return before anyone else is paid. If multiple rounds include 2x preferences, the total payout to preferred shareholders can grow quickly, especially if combined with stacked seniority, potentially exhausting most or all of the exit value.

Scenario modeling is essential to understand the impact of different multiples. Preference structures, while common, can significantly shape exit outcomes and should be carefully reviewed during fundraising.

Types of Liquidation Preferences

1. Non-Participating Preferred

This is the most common and founder-friendly structure. The investor receives either their initial investment (e.g. $5M) or their pro-rata share of the exit: whichever is greater, but not both.

For example, in a $20M sale, a $5M investor with 25% equity gets $5M either way. If the exit is $40M, they convert to equity and receive $10M.

This structure protects investors on the downside while preserving upside for the team: making it a widely accepted default in early-stage deals.

2. Participating Preferred

In this more investor-favorable model, the investor receives both their investment back and a share of the remaining proceeds.

Using the same example: in a $20M exit, the $5M investor first gets their $5M back, then 25% of the remaining $15M ($3.75M) — totaling $8.75M.

This “double dip” reduces what’s left for founders and employees and can distort incentives in modest exits. If used, founders should negotiate limits.

(a) Capped Participation

This structure offers participation, but with a cap (typically 2–3x the original investment) to prevent disproportionate investor returns.

In a $40M exit, a 2x cap limits the investor’s total to $10M, even if their full share would otherwise exceed that.

Capped participation is a middle ground: it still protects investors but ensures the team shares in large exits. It's often a practical compromise in later rounds.

(b) Uncapped Participation

The most investor-advantaged model. Investors get both their preference and unlimited upside — with no cap.

In a $100M exit, a $5M investor with 25% equity takes home $28.75M: $5M preference + $23.75M from participation.

Uncapped participation can severely dilute founders in large exits. Though rare in early-stage deals, it may appear in late or distressed rounds. Founders should model outcomes carefully.

Participation Rights Model

For clarity, take a look at the decision tree below.

Non-Participating Preferred

What the investor receives:

The greater of:

• 1x their original investment, or
• Their pro-rata share of the exit proceeds.

The investor chooses either the liquidation preference or their equity share: not both.

Participating Preferred

What the investor receives:

• First: return of 1x their original investment.
• Then: their pro-rata share of the remaining proceeds (alongside common shareholders).

This structure can be:

(a) Capped Participation

• Example: investor receives up to 2x total return.
• Once the cap is reached, they receive no additional proceeds.

(b) Uncapped Participation

No limit on total return: investor receives 1x plus their equity share, with no maximum.

What Founders Can Do

Preferences can help close deals, but only if balanced: preferences can protect capital and align risk, but they must be balanced. Not all preferences are bad. They help close deals. But founders must structure them thoughtfully:

• 1x non-participating is generally founder-aligned.
• If participation is requested, push for a cap.
• Avoid stacking across rounds or negotiate pari passu treatment.
• Always model outcomes using a cap table simulator (like Carta or Pulley).

Negotiate with the exit in mind: your future self (and your team) will thank you.

Final Thoughts

Liquidation preferences are not just legal details: they’re financial levers that impact incentives, morale, and outcomes. Founders should go beyond surface-level understanding and assess how each term will affect their team and their future. Even a “standard” clause can lead to misaligned expectations and painful surprises in an exit.