What is Liquidation Preference?
Liquidation Preference is a critical clause in a Term Sheet that establishes the hierarchy of who gets paid when a company undergoes a liquidity event, such as an acquisition, merger, or bankruptcy. It dictates that investors receive a return on their capital before common shareholders (employees and founders) see any money.
It serves as the investors' downside protection. If the company sells for less than the total amount of money they put in, this clause guarantees they recover their principal first.
The Two Types (The Founder's Focus) The preference is usually expressed as a multiple (e.g., 1x or 2x) and whether it is participating:
- 1x Non-Participating (Founder-Friendly): The investor gets EITHER their investment amount back OR their percentage share of the company proceeds. They choose the option that yields the higher return. This is clean and standard.
- 1x Participating (Investor-Friendly / "Double Dip"): The investor gets their initial investment back AND then receives their percentage share of the remaining proceeds. They get their money back first, and then take their slice of the rest of the pie.
Key Takeaway: Always negotiate hard for a 1x Non-Participating preference. A participating preference (the "double dip") can drastically reduce the payout founders and common shareholders receive in a smaller exit.
