Liquidation preferences

Northwind Labs sells for $40M. Ada, Ben, and the team own 80% of the company, so they think that they get $32M. They get $30M. With a different clause in the same term sheet, they get $24M, or less. This lesson explains the clause that moves those millions: the liquidation preference.

Why a sale counts as a liquidation

A liquidation preference is the right of preferred holders to get their money back before common holders get anything. The word “liquidation” makes you think of a company that closes. But the preference matters most in a sale. The charter treats a merger in which the stockholders lose control, or a sale of almost all of the assets, as a deemed liquidation event. Thus a sale starts the preference, the same as a shutdown. When a company closes, usually no money is left to divide.

This lesson uses one example. Northwind’s Series A investor pays $10M for 2,000,000 preferred shares at $5.00 each. This price is the original issue price. The founders and the team hold 8,000,000 common shares. Thus the investor owns 20% as converted, and the post-money valuation is $50M.

1x non-participating: the larger of two amounts

The standard preference is 1x and non-participating. In a sale, the investor selects one of two amounts:

• Its preference: 1 × its money, which is $10M
• Its as-converted share: it converts to common and takes 20% of the sale.

The investor takes the larger amount, never the two together:

Investor payout = the larger of
  the preference, or
  ownership × sale price

$40M sale:
  Preference    = $10M
  20% × $40M    = $8M
  -> keeps the $10M preference

$100M sale:
  Preference    = $10M
  20% × $100M   = $20M
  -> converts and takes $20M

In the $40M sale, the investor gets $10M and the common holders get the other $30M. That is why the team gets $30M, not 80% of $40M.

Predict first

At what sale price does the investor start to get more from conversion than from its $10M preference?

Type a guess before you continue. A guess first, even a wrong one, makes the answer easier to remember.

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The sale price where conversion starts to pay more is the conversion point:

Conversion point
  = preference ÷ ownership
  = $10M ÷ 20%
  = $50M

Try the preference terms

Move the sale price in the widget. Then change the participation and the multiple, and look at how the two lines bend.

Simulator

One investor, one sale

Pick the preference terms and a sale price. See how the money divides between the investor and the common holders.

Sale price

$40M

Participation

NoneFullCapped

Preference multiple

1x1.5x2x3x

Investment

Investor's ownership, as converted

20%

Investor gets

$10M

20% as converted is $8M

Common gets

$30M

$40M − $10M

Common's part

75%

Common owns 80%

Converts at

$50M

$10M ÷ 20%

How this sale divides

• Investor
• Common holders

Payout at every sale price

• Investor
• Common holders

20% as converted is $8M, less than the $10M preference. The investor keeps the preference, and common gets the other $30M. The investor converts only at a sale price more than $50M.

Participating preferred: the double dip

Participating preferred gets its preference and a share of the rest. Founders call it the “double dip.” The steps for a $40M sale:

Worked example · step 1 of 4

A $40M sale with 1x participating preferred

1. 1

   Pay the preference

   The investor gets its $10M first.

   $40M − $10M = $30M left

Show step 2Show all steps

As a percentage, participation costs the common holders the most in small and medium sales:

• From $10M to $50M, participation takes 20% of the money that common gets with a non-participating preference.
• At more than $50M, the cost stays at $8M: the $10M preference × 80%. At a larger sale, that $8M is a smaller percentage: 10% of the common money at $100M, and 3.3% at $300M.

Small and medium sales occur much more frequently than very large sales. Uncapped participation also never converts, because the double dip always pays at least as much as conversion.

Capped participation and the dead zone

A participation cap sets a maximum on the total payout of a participating investor, often a multiple of its money. Carta calls caps of two or three times the investment typical. With a 3x cap, Northwind’s investor can get at most $30M from the preference and the participation together. At a high sale price, the investor converts instead:

The payout reaches the cap at
  preference
  + (cap − preference) ÷ ownership
  = $10M + ($30M − $10M) ÷ 20%
  = $110M

The investor converts at more than
  cap ÷ ownership
  = $30M ÷ 20%
  = $150M

From $110M to $150M, the investor’s payout stays at $30M. In this dead zone, the common holders get each added dollar of the sale. Set the participation to “Capped” in the widget, and find the flat part of the investor line.

Multiples: 2x and more

A preference multiple of 2x pays the investor two times its money before common gets anything. With a 2x non-participating preference, Northwind’s investor takes $20M first. In a $20M sale, common gets nothing. The conversion point also doubles, to $20M ÷ 20% = $100M. The 2x preference pays the same as 1x only at $100M or more.

The table puts the four structures side by side. Each cell gives the investor’s payout, then the common holders’ payout, in millions of dollars:

Cumulative dividends make the preference grow

A term sheet can also add dividends to the preference. With cumulative dividends, a yearly percentage accumulates, the same as interest on a loan. The company does not pay it in cash, but it adds the total to the preference. Term sheets that have this clause usually set a rate of 5% to 8%:

Preference after 5 years
  = $10M + ($10M × 8% × 5 years)
  = $10M + $4M
  = $14M

In a $40M sale, common now gets $26M, not $30M. The conversion point also moves, from $50M to $14M ÷ 20% = $70M. Non-cumulative dividends, which the company pays only if the board declares them, cost the founders nothing. Cumulative dividends are rare, but the numbers vary by data set. Wilson Sonsini found them in 1% of its 1H 2026 deals, and Cooley found accruing dividends in 3% of its Q2 2026 deals.

Seniority: two rounds, one small sale

With two or more rounds, the charter also sets the order of payment between the series of preferred stock. This order is the seniority:

• Stacked: the newest round is senior. It gets its full preference first, then the round before it, and so on.
• Pari passu: the series rank equally. They divide the money in proportion to the size of their preferences.

Pari passu is Latin for “on equal footing.” For example, Northwind’s Series A has a $10M preference, and its Series B has a $20M preference. The total is $30M. A buyer pays $25M:

Stacked, Series B senior:
  Series B = $20M
  Series A = $25M − $20M = $5M

Pari passu:
  Series A = $25M × 10 ÷ 30 = $8.33M
  Series B = $25M × 20 ÷ 30 = $16.67M

The common holders get nothing in the two cases. If the buyer pays $40M, the order does not matter. Each series gets its full preference, and the common holders get the remaining $10M.

Simulator

Who comes first: stacked or pari passu

Series A has a $10M preference and Series B has a $20M preference, $30M in total. Move the sale price and change the order of payment.

Sale price

$25M

Order of payment

Series B firstPari passu

Series B gets

$20M

Pari passu: $16.67M

Series A gets

$5M

Pari passu: $8.33M

Common gets

$0

Pari passu: $0

Payout at every sale price

• Series B
• Series A
• Common

The sale pays $25M against $30M of preferences, so common gets nothing. Series B is senior, so it takes its full $20M first. Series A gets the last $5M. Pari passu, Series A gets $8.33M.

What is market in 2025-2026

Practice

Work it out

An investor puts in $6M for 25% with a 1x non-participating preference. The company sells for $20M. How much does the investor get?

Your answerCheck

Work it out

Use the same deal, but the preference is participating, with no cap. The company sells for $20M. How much do the common holders get?

Your answerCheck

Quiz · question 1 of 6

Test what you learned

An investor puts in $10M for 20%, with a 1x non-participating preference. The company sells for $40M. What does the investor get?

• A$18M
• B$8M
• C$10M
• D$16M