Liquidation Preferences: A Simple Breakdown of Exit Terms

A simple breakdown of liquidation preferences – the exit term that decides who actually gets paid and how much.

When founders negotiate a term sheet, valuation usually takes the spotlight. But hidden in the fine print is a clause that can matter more in determining who actually gets paid in an exit: liquidation preferences. Investors call them "downside protection." Founders sometimes call them "the silent killer." Both are right.

Below is a clear, app‑ready explanation plus a text version of the example in your image.

What are liquidation preferences?

Liquidation preferences set the rules for who gets paid first (and how much) when a company exits, whether through acquisition, IPO, or even bankruptcy.[1]

Preferred shareholders (investors) almost always sit ahead of common shareholders (founders and employees), which was originally designed to protect investors in smaller‑than‑expected outcomes.[2]

In practice, this can heavily skew who actually takes home money at exit, especially when exit values are close to or below the total capital raised.[1][2]

Common preference structures

Here are the main flavors your users will see in term sheets:

• 1x non‑participating (standard, more founder‑friendly)
  The investor gets back their original investment or converts to common stock and takes their ownership percentage, whichever is worth more, but not both.[1]
• Participating ("double dip")
  The investor first gets their money back, then participates pro rata in what is left alongside common shareholders.[2][1]
• Multiples (2x, 3x, etc.)
  The investor is entitled to 2–3x their original investment before common stockholders get anything; these are very investor‑friendly and were more common in overheated markets.[2]

The key intuition for your users: preferences define the "waterfall." Money flows to investors up to their preference amount first, and only the leftovers (if any) go to common.

Scenario setup (from the image → table)

Use this table instead of the graphic:

Liquidation preference structures in this example:

• 1x non‑participating: Investor chooses between getting 20M back or taking 20% of the 40M exit via common.
• 1x participating: Investor gets 20M back, then also receives 20% of the remaining proceeds.
• 2x non‑participating: Investor is entitled to 40M before others; if exit is only 40M, this can wipe out common completely.[1][2]

Payout math for each structure

Given: investment 20M, ownership 20%, exit 40M.

1) 1x non‑participating

• Preference path: Investor takes 1x = 20M, common gets the remaining 20M.
• Conversion path: If investor converted to common, they would get 20% of 40M = 8M.
• Investor chooses the higher of 20M vs 8M → takes 20M.
• Result:
  • Investor: 20M
  • Founders/employees (common): 20M

2) 1x participating ("double dip")

• Step 1 – preference: Investor gets 1x = 20M off the top, leaving 20M.
• Step 2 – participation: Investor also gets 20% of the remaining 20M = 4M.
• Result:
  • Investor: 24M total (20M + 4M)
  • Founders/employees (common): 16M

3) 2x non‑participating

• Preference: Investor is entitled to 2 × 20M = 40M before common.
• Exit equals 40M, so the entire exit goes to satisfy the preference, with nothing left over.
• Result:
  • Investor: 40M
  • Founders/employees (common): 0

This is the exact "paper millionaire to zero" pattern your app will want to highlight: mid‑range exits plus heavy preferences can mean common holders get nothing even when headline prices look good.[2]

How to explain this in your app

For non‑finance users, keep it punchy:

• "Preferences decide who gets paid first in a sale."
• "1x non‑participating: investors choose either their money back or their % of the sale."
• "Participating: investors get their money back and a % of what's left."
• "2x+ preferences: investors can take everything in small or mid‑sized exits; employees may get zero."

Then let users plug in three numbers—capital raised, preference multiple, and a hypothetical exit—and show two big cards:

• "Money investors get before you: ≈ X"
• "What's left for common (you, founders, employees): ≈ Y – which could be 0 in some scenarios."

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