Liquidation preference example: who gets what at the exit

What a liquidation preference is

Venture investors buy preferred shares, not the common shares that founders and employees hold. The most important right attached to them is the liquidation preference: when the company is sold, merged or wound down, the preferred shareholders get a set amount back before common shareholders receive anything.

• The multiple sets the amount: a 1x preference returns the investment once, a 2x preference twice.
• Participation decides whether the investor also shares in what is left after the preference.
• A cap limits the total a participating investor can take.

A "liquidation event" in a term sheet usually includes a sale of the company, not just a bankruptcy. That is why these terms matter most in ordinary, modest exits.

Non-participating: preference or conversion, whichever pays more

A non-participating investor has a choice. Either take the preference, which is capped at the exit value because you cannot pay out more than there is, or convert to common and take the ownership share of the whole exit. In Excel:

=MAX(MIN(exit, preference), exit × ownership)

The two options are equal at the conversion point: preference ÷ ownership. Here that is $10m ÷ 25% = $40m. Below it the investor takes the preference, above it the investor converts.

Worked example: Series A payout at four exit values

Inputs are yellow. The column formulas are copied across, the list shows exit A. Exit value means the proceeds left for shareholders after debt and deal costs.

Worked example: Series A payout at four exit values

	A	B	C	D	E
1	Series A terms	Value
2	Series A investment ($m)	10.0
3	Preference multiple (x)	1.00x
4	Liquidation preference ($m)	10.0
5	Series A ownership, as converted	25.0%
6	Participation cap (x investment)	3.00x
7
8	Payout at exit ($m)	Exit A	Exit B	Exit C	Exit D
9	Exit value (to shareholders)	8.0	25.0	60.0	150.0
10	1x non-participating
11	Option 1: take the preference	8.00	10.00	10.00	10.00
12	Option 2: convert to common	2.00	6.25	15.00	37.50
13	Series A receives	8.00	10.00	15.00	37.50
14	Common receives	0.00	15.00	45.00	112.50
15	1x participating
16	Preference first	8.00	10.00	10.00	10.00
17	+ Share of the rest	0.00	3.75	12.50	35.00
18	Series A receives	8.00	13.75	22.50	45.00
19	Common receives	0.00	11.25	37.50	105.00
20	1x participating, capped at 3x
21	Participation up to the cap	8.00	13.75	22.50	30.00
22	Series A receives (or converts)	8.00	13.75	22.50	37.50
23	Common receives	0.00	11.25	37.50	112.50
24
25	Conversion point, non-participating	40.0
26	Conversion point, capped participation	120.0

One preferred class, no option pool and no dividends on the preferred, to keep the mechanics visible. Educational, not legal or investment advice: the actual terms are in the company's charter.

Walking through the four exits

• $8m: less than the $10m preference, so the investor takes all $8m and common gets nothing. This is the case the preference was written for.
• $25m: the preference of $10m beats 25% of $25m ($6.25m). Common receives $15m.
• $60m: converting pays $15m, more than the preference, so the investor converts. Common receives $45m, exactly 75% of the exit.
• $150m: the investor converts and receives $37.5m, common $112.5m.

Above the conversion point a non-participating preference has no effect at all. Everyone is paid by ownership, just as if all shares were common.

Participating preferred: the double dip

A participating investor takes the preference and its ownership share of whatever is left:

=MIN(exit, preference) + (exit − preference paid) × ownership

At $25m that is $10m + 25% × $15m = $13.75m. At $60m it is $22.5m instead of $15m, and at $150m $45m instead of $37.5m. Above the conversion point the participating investor always receives preference × (1 − ownership) more than a non-participating one, here $10m × 75% = $7.5m, and that money comes straight out of the common shareholders' pocket.

Capped participation

A cap is the usual compromise. With a 3x cap the participating investor can take at most 3 × $10m = $30m in total, preference included. Once the cap binds, the investor still has the right to convert, so the payout is =MAX(MIN(participating payout, cap), exit × ownership).

At $150m the capped participation would pay $30m, but converting pays $37.5m, so the investor converts and the result is the same as non-participating. The participation reaches the cap where $10m + (exit − $10m) × 25% = $30m, at an exit of $90m. From there up to the second conversion point, $30m ÷ 25% = $120m, the investor's payout stays flat at $30m.

Several rounds and the preference stack

Real companies have several preferred classes: seed, Series A, Series B. Their preferences add up to a preference stack that must be paid before common sees anything. Later rounds are often senior, paid first, or rank pari passu with earlier ones, sharing in proportion to their preferences. Each class then makes its own convert-or-not decision. In the spreadsheet, you run the waterfall class by class, from the most senior down.

Ownership itself shrinks with every round and with the option pool, which the dilution lab covers. Notes and SAFEs usually convert into the next round's preferred shares, so they end up in the stack too. Buyouts work differently again: there the sponsor's equity sits below a large amount of debt, as the LBO model example shows.

What is common in term sheets

A 1x non-participating preference has long been the most common term in venture rounds. Participation, multiples above 1x and senior preferences show up more often in later-stage rounds and when money is hard to raise. When you compare two term sheets, do not only compare the valuation: run both through this kind of waterfall at a few realistic exit values. A higher valuation with participation can leave founders with less at a modest exit than a lower valuation without it.

Common mistakes

• No MIN on the preference. At an $8m exit the investor cannot get $10m. Cap the preference at the exit value.
• Giving a non-participating investor both. Non-participating means preference or conversion, never preference plus a share of the rest.
• Using the cap as extra money. A 3x cap limits the total payout, preference included. It is not 3x on top of the preference.
• Forgetting the conversion option under a cap. A capped investor converts when its ownership share is worth more than the cap.
• Starting from enterprise value. Debt, transaction fees and management bonuses come off first. The waterfall splits what is left for shareholders.
• Ignoring other preferred classes. With several rounds, the senior preferences are paid first and can absorb the whole exit.