Liquidation Preferences

Term Sheets Part VII: Liq Prefs

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Daniel Faierman & Chuck Cotter
June 12, 2025

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Daniel Faierman is a Partner at Habitat Partners, an NYC-based early stage VC firm focused on pre-seed to Series A investments in the consumer and software ecosystems. Learn more about Habitat Partners on their website or notion page. Daniel has invested in numerous startups and previously operated and invested at organizations including PepsiCo, AB InBev, VMG Partners, and Selva Ventures. Daniel was a former Yale tennis 🎾 player & completed his MBA at the Stanford Graduate School of Business.

Chuck Cotter is a Partner in Morrison Foerster’s Emerging Company + Venture Capital practice group in Denver, with experience in the consumer products space, including food, beverage, personal care, beauty, and fashion. He has represented such companies and funds in over 200 🚀 consumer financing and M&A transactions. Chuck was a rugby player at Vassar College and completed his JD at Columbia Law School.

Liquidation Preferences ⏯️ 

We apologize for taking an extra week to drop our next post. Has been a wild moment for both of us. But we are back and excited to chat liquidation preferences. On a side note, I thought the below image was interesting regarding some of the commentary we have made over the last few weeks on the dangers of “stacking SAFEs/Notes.”

Now for liquidation preferences 🏃 

Congrats! You've made it through SAFEs and convertible notes. Now it's time for the big leagues: liquidation preferences. Don't worry - we promise this isn't as scary as it sounds (though it can definitely make or break your exit 😱). If you've been following along, you know that negotiating conversion terms matters big time. But here's the thing - once those SAFEs and notes convert into preferred stock, liquidation preference becomes a central term. It's literally what determines how your exit “will play out.”

In today’s post, we’ll dive into the following:

What is a liquidation preference?

Corporations can have multiple types of stock, usually separated into classes of “preferred stock” and “common stock.” Commons stock is generally used to incentivize the founders and service providers by giving them a vested interest in the company’s future, but its usually vanilla, meaning it only has rights provided by default under applicable law, and no special bells and whistles. It also usually has a (considerably) lower 409A valuation than preferred stock.

Liquidation Preference is one of the rights that makes preferred stock more valuable than common stock and a large part of why investors agree to purchase the right to preferred stock (i.e., SAFEs or convertible notes) or purchase preferred stock directly during financings. Liquidation preference is the legal entitlement to receive a pre-determined portion of a company’s value in the event of a sale or liquidity event before the holders of common stock (i.e. the right to get paid first in an exit). Liquidation preference may also be called “preferred return of capital,” “preference,” or “liq pref” for those keen on shorthand.

After liquidation preferences are satisfied, the remaining exit proceeds are distributed to all “participating stockholders.”

Why does liquidation preference matter and what type of liquidation prefs exist?

Picture this: You sell your company for $200 million. Sounds amazing, right? Plot twist - the founders walk away with $0. How? Liquidation preference.

This isn't theoretical. It's happened. Multiple times. Liquidation preference creates the hurdle founders need to clear before seeing any return. It's the difference between "we sold for hundreds of millions!" and "we sold for hundreds of millions... but got nothing."

What are the three levers of liquidation preference?

Preference can be highly negotiated and customized, but the three key terms are the (i) seniority, (ii) multiplier and (iii) participation rights.

Seniority refers to whether preference is senior, junior or even (pari passu) with other preferred stock. Senior preference means having a first-tier liquidation right, junior preference means having a liquidation right that is paid after the senior preferred and pari passu means preference amongst different preferred stock is the same time.

The Multiplier refers to the multiple on the original price per share of a class or series of preferred stock an investor is entitled to receive before others get paid. A 1x preference means getting paid one times the original investment, a 3x preference would mean getting paid three times the original investment back before the next most senior preference is paid.

Participation is the right of a preferred stock to participate in remaining acquisition proceeds (on an as-converted to common stock basis, along with common stock) after the initial multiplier liquidation preference is satisfied. When preferred stockholders have a participation preference it’s called “double dipping” as preferred stockholder enjoys preferential return of capital in liquidation preference and then enjoys pro rata share of remaining proceeds. Participation can be capped (limited to a certain multiple) or uncapped.

A few examples leveraging the variables above (hopefully the examples make it much clearer how all of this comes together):

Example #1:

  • 1,000,000 shares of common stock

  • 1,000,000 shares of Series A preferred stock ($2.00 per share liquidation preference) with a 1x preference (aka multiplier) and no participation rights

Outcome #1: Acquisition at $10 million 👍️ 

  • Series A decides between taking their $2 million in liquidation preference value (1,000,000 shares @ $2.00 share x 1x preference = $2 million) OR converting to common shares and taking their pro rata share of proceeds (which is 50% = 1,000,000 in shares owned by Series A / 2,000,000 in total shares outstanding).  So they take their pro rata instead of their preference because 50% x $10M = $5M in proceeds, which is greater than $2M in preference. The common with 50% ownership will also receive $5M (not bad!).

Outcome #2: Acquisition at $1 million 👎️ 

  • Series A gets all $1 million and common gets nothing (Series A gets 100% of proceeds as a 50% owner). Ouch! This is the power of a liquidation preference.

See below for a simple liquidation preference scatterplot of the example above. This is a common exercise that VCs complete when simulating exit outcomes at time of investment and is valuable to understand as a common shareholder (founder) as well.

Example #1: Exit Outcome Scatterplot

  • As you can see the common only participate in the proceeds at a threhold above $2M in exit value. Otherwise, the Series A investors take all the proceeds.

  • $4M in exit proceeds is the indifference point in which Series A shareholders would be rewarded with $2M in proceeds whether they convert to common or exercise their liquidation preference.

  • If exit proceeds surpass $4M, Series A investors convert to common and split the proceeds with the common.

Example #2:

  • 1,000,000 shares of common stock

  • 1,000,000 shares of Series A preferred stock ($2.00 per share liquidation preference) with a 2x preference (aka multiplier) and uncapped participation rights

Outcome: Acquisition at $10 million 👍️ 

  • If the Series A investor takes their liquidation preference and participates (converts to common to get their share of the remaining proceeds), they are awarded $7M in proceeds!

    • Exercise liquidation preference: 1,000,000 shares @ $2.00 share x 2x preference = $4 million

    • Participate in remaining proceeds: there is $6M in remaining proceeds after Series A investor takes their $4 million in preference. The Series A investor will then convert to common and take 50% of the remaning $6M in proceeds equating to $3M in additional payout to the Series A

    • Therefore, the Series A takes $7M ($4M + $3M) in proceeds and the Common takes the remaining $3M

Example #2: Exit Outcome Scatterplot

  • As you can see the common only participate in the proceeds at a threshold above $4M in exit value. Otherwise, the Series A investors take all the proceeds.

  • Driven by the combination of the 2x multiplier and participation, the Series A have a very advantaged position for all exit outcomes.

Example #3:

  • 1,000,000 shares of common stock

  • 1,000,000 shares of Series A preferred stock ($2.00 per share liquidation preference) with a 1x preference (aka multiplier) without participation

  • 1,000,000 shares of Series B preferred stock ($2.00 per share senior liquidation preference) with a 2x preference (aka multiplier) without participation

Outcome: Acquisition at $10 million 👍️ 

  • Series B shareholders (who own 1/3 of the company if they convert and thus would be awarded ~$3.3M dollars) will exercise their liquidation preference to get $4M in proceeds (> $3.3M).

  • Series A shareholders can either exercise their liquidation preference and receive $2M in proceeds or convert to common. Since the Series B shareholders did not convert to common, when the Series A shareholder convert to common they have the right to 50% of the remaining proceeds since they will convert into 1,000,000 shares of common stock with a total of 2,000,000 shares of common stock outstanding (the Series B shares are not part of the common since they did not convert). 50% x $6M in remaining proceeds = $3M in payouts to the Series A shareholders (> $2M they would receive if they exercised their preference).

  • Common is left with $3M in remaining proceeds.

Example #3: Exit Outcome Scatterplot

Standard preference practices for founders & investors

From Chuck’s perspective: Non-distressed companies should negotiate for and agree to issue non-participating preferred stock with a 1x multiplier and which are pari passu i.e., even with all existing preferred stock (if any). This keeps everyone’s interests aligned, because once you start adding seniority, multipliers above 1x, or participation rights, people start rooting for different outcomes that are best for them. TL;DR preferred stock with a 1.0x, non-participating preference is equal in value to common stock if you grow the price per share value from the time they invest.

To show how this impacts distributions, take an example in which preferred investors have invested $3,000,000 with a 1x, nonparticipating liquidation preference, and they own 30% of the company. The distributions on an exit would look like this:

90% of rounds Daniel has participated in historically have entailed 1x non-participating. Variations to this standard are seen more often in later stage deals (growth equity + private equity) and down rounds / distressed deals. In certain cases a later stage investor may be less valuation sensitive if they can mandate a liquidation preference that nears their target MOIC (i.e., 3x). This can backfire if a company is overvalued and then faces challenges growing into their valuation in the future (and then is forced to potentially take a down round).

The connection to SAFEs/Convertible Notes

Here's where your previous SAFE and convertible note decisions come back to haunt (or help) you. Most SAFEs and notes say: "convert me into whatever preferred stock terms you give the lead investor."

Translation: Whatever preference terms a company agrees to with the equity financing lead automatically get shared with ALL of the SAFE and convertible note holders. Agree to 2x participating preference? Congrats, now EVERYONE has 2x participating preference. Your common stock hurdle just got a lot higher. Be careful as a founder.

Full participation v. capped participation

Fully participating preference is like having your cake and eating it too - investors get their preference AND participate in remaining proceeds. For smaller exits, this creates outsized returns for preferred stockholders while common gets crushed. But as an investor, be careful – if you ask for (and get) this right, all investors who come in later will want it to.

Capped participation puts a ceiling on the madness. At some point, it becomes better for preferred stockholders to convert to common and participate evenly. It's still not great for founders, but at least there's a limit.

Full Participation Example

Capped Participation Example

To expand on our chart example above, if you add participation to the exit with a 1x liquidation preference, and the preferred stockholders hold 30% of the company, you can see how the distributions change:

To further expand on our example in the charts above, below shows what happens if we add a 3x cap on the participation:

Loss of preference during cram downs

Sometimes when a company has previously issued preferred stock but is not doing well, a recapitalization will be proposed, often called a “cram down” where existing preferred stock loses its preference. Cram downs generally accompany pay-to-plays whereby those who invest more in the company (typically a pro-rata amount of the total financing relative to their pre-financing ownership) can keep their preference (or “get pulled through” to a better preference) and those who do not will lose it (or not get “pulled through”). Typically, existing preferred stockholders will see their shares converted to common stock at a pre-determined ratio and if they participate, they will see their shares pulled through to a class of new preferred stock with new preference rights. This can create a “preference reset.”

Liquidation Preference tl;dr takeaways

1. Preference is largely irrelevant during SAFE and convertible financing rounds but is generally one of the most important economic term of priced financing rounds.

2. Preference will determine whether an exit scenario is preferable (no pun intended) for investors and/or founders. Founders with attractive companies in the venture stage should generally ask for 1.0x, non-participating. 

3. Providing an off-market preference will inspire the next round of investors to ask for the same or better.

4. Preference isn’t forever – it can be lost in the event of a cram-down, and can lead to disharmony between different classes of investors.

5. Of course, investors may ask for more “structure” (more than 1x and/or participation feature) just because they can or to see if they can get it. But often they ask for it if they feel like a deal is over-priced and they need to build in return. 

If you enjoyed this article, feel free to view recent prior articles:

Ongoing Term Glossary

Automatic Conversion: in the context of convertible notes (or SAFEs), a clause that triggers a convertible note to automatically convert into equity at maturity

Bridge Financing: when investors agree to provide temporary financing to secure a company’s cash balance before the company raises their next priced round - aka the bridge that gets you to your next priced round.

Capped Price: conversion price per share awarded to noteholder (or SAFE holder) if investor exercises valuation cap

Change in control: a significant shift in the ownership or control of a company, often triggering specific rights or obligations for investors (M&A most commonly)

Clawback provisions: provisions that give the company the right to buy back vested shares at the original issue price or at fair market value after dismissing an employee under defined circumstances (leaving for a competitor, severe misconduct, etc)

Co-Invest: triggered when a fund raises “one-off” new capital from LPs/investors (as opposed to pulling from existing permanent fund) to unlock ability to execute an investment; associated management fees and carry (if any) typically flow back to the fund or individual who raised the co-invest capital. Funds often give major LPs prioritized “co-invest“ rights, which gives such LPs the first rights to participate in the co-invest opportunity before others.

Comparable Company Analysis: a valuation methodology that entails identifying comparable companies and transactions to the company being valued as a means of deriving multiples that can be used to generate a landed valuation

Confidentiality: prevents the startup from disclosing the terms of a term sheet to outside parties (i.e., other investors, startups). This enables both parties to negotiate in good faith.

Convertible Note: a debt instrument that can be converted to equity based on the occurrence of certain events (most commonly during a priced equity financing round).

Conversion: convertible notes (and SAFEs) automatically convert into equity if certain triggers occur. The most common trigger that leads to the conversion of a convertible note (or SAFE) into equity is a priced equity financing round

Debt repayment terms: in the context of convertible notes, defines specifics associated with principal, interest rate, maturity date, and default provisions.

Definitive documents:  the legal contracts between the investors and the company that detail the terms of the transaction and are drafted by a lawyer

Dilution (D): losing a portion of your ownership as the company sells equity to investors

Discounted Cash Flow Analysis (DCF): a valuation methodology that entails forecasting the future cash flows of a business and discounting the cash flows by a determined cost of capital to derive an enterprise value

Discount: a discount is a term awarded to the convertible noteholder (or SAFE holder) that drives a reduction in the conversion price per share that they are awarded during a qualified financing. Discounts typically range from 10-30% with 20% being the most common.

Down Round: when the pre-money valuation of a future financing is lower than the post-money valuation of the prior financing; often seen as a negative sign for the company

Double-trigger: requires two events to occur to accelerate the completion of your vesting. The first trigger is the acquisition, and the second trigger is the founder or employee getting terminated by the acquirer without cause or good reason in a specified period (typically one year)

Employee Option Pool (EOP): stock that is reserved for existing and future employees to compensate, retain, and motivate workforce

Equity conversion terms: in the context of convertible notes, defines the specific event(s) that triggers conversion of debt to equity, the formula used during conversion (considering the impact of the valuation cap and/or discount – to be discussed), the type of equity received upon conversion by the note holder (common vs. preferred equity), and any associated rights the new equity holders will get after their convertible note is converted to equity (voting, dividends, etc).

Exclusivity: often referred to as a “no shop,” this provision locks parties into negotiating only with each other for a defined period (i.e., 30-60 days)

Exercise (options): buy options at the strike price

Fund Model: a forecasting exercise that a VC conducts to project what a successful fund will look like in terms of returns from each investment. VCs typically build a pathway to 3.0x net DPI

Indifference point: the price per share at which the noteholder or SAFE holder is indifferent between exercising the discount or valuation cap

Interest Rate & Payments: convertible notes often feature interest rates. Unlike a traditional loan, startups rarely pay the interest in cash to the convertible noteholder periodically. Instead, convertible notes accrue interest until the time of conversion.

Lead Investor: primary investor(s) (co-leads can exist) in a funding round that set terms and typically are writing the largest check(s); often take a board seat

Legally nonbinding: refers to the nature of term sheets. A signed term sheet does not legally mandate a deal be completed

Liquidation Preference: is one of the rights that makes preferred stock more valuable than common stock and a large part of why investors agree to purchase the right to preferred stock (i.e., SAFEs or convertible notes) or purchase preferred stock directly during financings. Liquidation preference is the legal entitlement to receive a pre-determined portion of a company’s value in the event of a sale or liquidity event before the holders of common stock (i.e. the right to get paid first in an exit).

Ownership (O): the % of a company a shareholder possesses prior to or post-closing of a financing

Participation (Liquidation Preferences): is the right of a preferred stock to participate in remaining acquisition proceeds (on an as-converted to common stock basis, along with common stock) after the initial multiplier liquidation preference is satisfied. When preferred stockholders have a participation preference it’s called “double dipping” as preferred stockholder enjoys preferential return of capital in liquidation preference and then enjoys pro rata share of remaining proceeds. Participation can be capped (limited to a certain multiple) or uncapped.

Prepayment: in the context of convertible notes, payment of the principal and accrued interest by the startup before the note matures. This is generally only allowed if there is a majority of supermajority vote in favor of prepayment by the noteholders.

Major Investor: refers to a participating investor in a financing that surpasses a certain check size threshold, unlocking certain rights. I.e., “all those who invest over $500k will be deemed major investors and shall receive information and pro rata rights”

Maturity: the date at which the debt (plus any accrued interest) is due for repayment. This is typically 12, 18, or 24 months from the issuance of the convertible note. We will talk about conversion momentarily but the norm for a convertible note is that it has converted into equity prior to the maturity date

Maturity Extension: in the context of convertible notes, this entails moving the maturity date back. A common alternative to repayment is for the company and noteholders to agree to an extension on the maturity date of the note

Multiple: a ratio that is calculated by dividing the valuation of an asset by a specific item on the financial statements

Multiplier (Liquidation Preferences): Multiplier refers to the multiple on the original price per share of a class or series of preferred stock an investor is entitled to receive before others get paid. A 1x preference means getting paid one times the original investment, a 3x preference would mean getting paid three times the original investment back before the next most senior preference is paid.

Multiple on Invested Capital (MOIC): compares the value of an investment on the exit date to the initial equity contribution

Non-priced financing: financing round in which founder and VC do not explicitly set a share price and thus do not set an associated pre-money valuation (i.e., convertible notes, SAFEs)

Option pool: an amount of common stock primarily reserved in the cap table for future employees (in certain cases, options can be pulled out of the option pool for existing employees/founders as well)

Optional conversion: in the context of convertible notes, entitles the noteholder to convert their note into equity if desired if the note is still outstanding on the maturity date

Post-Money Valuation (PO): the valuation of the company after the round size is invested by the VC(s)

Pre-Money Valuation (PM): what the investor is valuing the company at TODAY, prior to the investment

Priced round/financing: a round of financing in which the valuation and price per share of a unit of stock being sold is officially determined (as opposed to a SAFE or convertible note in which case the valuation is left officially undetermined)

Price Per Share (PPS): the cost of acquiring a share of company x, typically determined by pre-money valuation and fully diluted shares outstanding prior to close of financing

Principal: in the context of convertible notes, the amount of investment provided by the noteholder (investor) to the company through the convertible note. In an unfortunate scenario where the note never converts to equity (we will discuss this), the principal (plus any accrued interest) is what the company owes the noteholder (unless nuanced legal terms dictate otherwise). Assuming the note does convert to equity (the norm), the principal (plus any accrued interest) is the quantity used to calculate how many shares the note holder will receive upon conversion into equity.

Pro rata rights: give investors the right (but not obligation) to participate in future rounds of financing to maintain their initial level of percentage ownership in the company.

Pro rata on a dollar-for-dollar basis: gives the investor the right to invest an amount equal to or less than the amount invested in their first round à VC Z invested 200K in the seed round and has the right to invest 200k in the Series A

Pro rata on a fixed sum basis: least common, investors get the right to continue investing an amount as agreed upon that is decoupled from the investment amount. VC Z, who invested $1M in a seed, negotiates pro rata rights up to $700K - they will be able to invest up to $700K in each subsequent round of financing.

Pro Rata ROFR: gives particular investor(s) the right to another investors voluntarily waived pro rata in a future financing  

Qualified financing: in the context of convertible notes/SAFEs, the round size of an equity financing typically must meet a certain dollar threshold to trigger conversion into equity.

Repayment: in the context of convertible notes, the process of paying back the debt (plus any accrued interest) due to noteholders

Restricted Stock: company stock given to employees, usually as a bonus or additional compensation; does not have a strike price unlike options; usually awarded to company directors and executives and is subject to vesting

Round Size or Investment Amount (R): how much capital the founder is raising for the financing or VC round

RSUs: refers to an agreement by a company to issue employees shares on a future date. One RSU is the right to get one common share. RSUs, like options, are also subject to a time-based vesting schedule and can be trigger based; however, RSUs don’t have a strike price and are instead released directly to the recipient after vesting without any need to “exercise” or buy them; typically awarded to lower level employees than restricted stock

SAFE: an agreement between an investor and a company that converts into equity in the next financing round if certain conditions are met

Seniority (Liquidation Preferences): refers to whether preference is senior, junior or even (pari passu) with other preferred stock. Senior preference means having a first-tier liquidation right, junior preference means having a liquidation right that is paid after the senior preferred and pari passu means preference amongst different preferred stock is the same time.

Single-trigger: states that only one event must occur to accelerate the vesting of your equity. If the company is acquired, you gain complete ownership over all your options

Stock options: incentive mechanisms granted to employees, advisors, and consultants. Employees joining a VC-backed startup typically receive an option grant, which allows them to acquire company common shares in the future at a certain price by “exercising vested options”

Strike Price: the predetermined price an employee pays to exercise (aka purchase) their stock options and turn their stock options into actual shares of the company owned outright. Tax regulations (IRS Section 409a) require options grants to have a strike price equal to or above the fair market value of the underlying company stock on the date that the option is granted

‘Success disaster’: employees run the risk of being harmed financially for building a succeeding business that has grown in value significantly

Uncapped Note/SAFE: a convertible note (or SAFE) that lacks a valuation cap

Up Round: when the pre-money valuation of a future financing is higher than the post-money valuation of the prior financing; often seen as a positive sign for the company

Valuation: the process of deriving an enterprise value for a company

Valuation Cap: a valuation cap is an investor favorable terms that puts a ceiling on the conversion price at which a convertible note or SAFE would convert into the equity security sold at the qualified financing.

VC Valuation Method: a valuation methodology that entails projecting a company’s exit value in the future and a VC’s required MOIC in order to back into an implied valuation and ownership level at time of investment (starting with the future and backing into the present)

Vesting: the process of gaining ownership over granted stock options

Voluntary conversion: in the context of convertible notes, gives the investor (noteholder) the power to convert into equity whenever desired (even before maturity) under specified details, negating any prepayment potential

Warrants: when issued/contracted, give the warrant holder the right to buy a certain number of shares of the company’s common or preferred stock at a predefined price over a specified period

PM + R = PO ➡️ the pre-money valuation plus the round size = the post-money valuation

PO – R = PM ➡️ the post-money valuation minus the round size = the pre-money valuation

PM / FDSO = PPS ➡️ the pre-money valuation divided by shares outstanding = price per share

R / PO = O ➡️ round size divided by the post-money valuation is the amount of ownership acquired in a financing by participating investors

D / PO = Daniel’s O ➡️ Daniel’s investment divided by the post-money valuation is the amount of ownership Daniel is acquiring in a financing

Fundraising

Rule #1: Communicate early and consistently. Goal: build long term relationships with a roster of investors before you kick off a process.

Rule #2: Ask for help. The only way to get maximal value out of your cap table is by asking for help. Especially when times are tough, great investors can potentially be the difference between make or break.

Rule #3: Keep knocking. As hard as it is, keep communicating with rejectors and make them aware of your progress.

Is there a topic you’d like us to cover? Don’t be a stranger! Ever want to dive deeper on a topic in VC Investing or Law?

We can be reached here:

Daniel Faierman ➡️ [email protected] 

Chuck Cotter ➡️ [email protected]

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✍️ Written by Daniel Faierman and Chuck Cotter 

Disclaimer: The information provided in this entry does not, and is not intended to, constitute legal or investment advice; instead, all information, content, and materials available in this entry are for general informational purposes only.