Liquidation preferences decide who gets paid first when a company sells or winds down. They set the order, the amounts, and the breakpoints. Get them wrong and founders and employees can end up with little at exit. Get them right and you protect investors while keeping real upside in common shares.
This guide breaks down liquidation preferences in clear English. We explain 1x, participating, and caps, then show step‑by‑step models with simple maths you can follow. You will learn how to build a spreadsheet waterfall, how to read term sheets, and how to spot traps.
For 2025, 1x non‑participating is common in healthy rounds. Participation and higher multiples crop up in down rounds or when risk is higher. Terms shape founder outcomes, employee morale, and investor returns. Follow the numbers and use the checklist at the end.
Liquidation preferences in plain English: what they are and why they matter
At exit, money flows in a line. Debt gets paid first, then preferred shareholders with liquidation preferences, then common shareholders. Preferences are a promise that investors get some money back before common takes anything.
Key ideas:
- Preference multiple: how many times the original investment must be paid back first, such as 1x or 2x.
- Participation: whether preferred also shares in the remainder after getting its preference.
- Caps: a limit on how far participation runs, for example up to 2x total return.
- Conversion: preferred can switch to common if that pays more.
Seniority rules set who goes first among preferred. That can be standard by series, for example Series B senior to Series A, or pari passu, where series share the pot at the same level.
One quick example. Investor puts in £5m for 25 percent. The company sells for £10m. With a 1x non‑participating preference, the investor chooses the higher of £5m or 25 percent of £10m, which is £2.5m. They take £5m. Common splits the remaining £5m. That choice highlights why founders and employees must care. The preference path can soak up most or all of the proceeds at low exits.
Key terms you will see on a term sheet
- 1x, 1.5x, 2x preference: return of original investment times the multiple before common is paid.
- Non‑participating: investor takes the higher of the preference or the value as common, not both.
- Participating: investor takes the preference first, then also shares pro rata in what is left.
- Cap on participation: a hard ceiling on total return from participation, for example 2x total.
- Seniority: stacked by series where later rounds sit ahead, or pari passu where series share level by level.
- Conversion to common: investor can switch to common shares if that gives a higher payout.
- Cumulative vs non‑cumulative dividends: unpaid dividends that pile up versus those that do not. They can add to the preference if cumulative.
- Liquidation event: a sale, merger, asset sale, or wind‑down that triggers the preference.
- Exit waterfall: the step‑by‑step flow of money at exit through debt, preferences, and common.
Seniority and stacking: who stands in line at exit
If Series B is senior to Series A, you pay Series B first up to its preference, then Series A, then common. If the terms are pari passu, Series A and Series B share the proceeds in proportion to their preferences at the same level.
Debt and other creditors come before all equity. That includes bank loans and often convertible notes that do not convert.
When stacked preferences add up to more than likely exit values, you get a liquidation overhang. Common sits under water. That hurts retention and makes new options less attractive.
What counts as a liquidation event
Common triggers:
- Sale of the company
- Change of control
- Merger
- Asset sale
- Wind‑down or dissolution
An IPO usually forces a conversion to common, so preferences drop away at listing. Watch for deemed liquidation clauses. Some documents treat large financings or asset sales as liquidation events. That can pull forward preferences when you least expect it.
Why founders and employees should care
Preferences can wipe out common at low exits. Stacked rounds and participation delay when common sees meaningful proceeds. This affects hiring and the value of the ESOP. Candidates ask what their options could be worth. If the preference stack is heavy, the answer may be bleak for a long time.
Model outcomes before you sign a term sheet. Share the results with the team. It creates alignment and reduces surprises.
1x non‑participating vs participating and caps: payout models with clear numbers
Base case: Investor puts in £8m for 40 percent ownership with a 1x preference. Model exits at £6m, £20m, £40m, and £80m. Compare three models.
- Model 1: 1x non‑participating
- Model 2: 1x participating
- Model 3: Participating with a 2x cap
We use simple steps and show when the investor switches from preference to common, and when the cap bites.
Model 1: 1x non‑participating preference
Rule: the investor takes the higher of the 1x preference (£8m) or the value as common, which is 40 percent of the exit.
- £6m exit: preference is £8m but only £6m exists. The investor receives £6m, common gets £0.
- £20m exit: preference pays £8m. Common value would be 40 percent of £20m, which is £8m. The investor is indifferent. Either path pays £8m.
- £40m exit: common value is £16m, which beats the £8m preference. The investor converts, gets £16m. Common gets £24m.
- £80m exit: common value is £32m, which beats the £8m preference. The investor converts, gets £32m. Common gets £48m.
The conversion breakpoint is exit value where common equals preference. £8m divided by 40 percent equals £20m. At exits above £20m, the investor converts.
Model 2: 1x participating preference
Rule: the investor gets 1x back first, then also shares pro rata in the remainder with common.
- £6m exit: investor takes up to the £6m available. Nothing remains. Common gets £0.
- £20m exit: investor takes £8m first, £12m remains. Investor then takes 40 percent of £12m, which is £4.8m. Total to investor £12.8m. Common gets £7.2m.
- £40m exit: investor takes £8m first, £32m remains. Investor takes 40 percent of £32m, which is £12.8m. Total to investor £20.8m. Common gets £19.2m.
- £80m exit: investor takes £8m first, £72m remains. Investor takes 40 percent of £72m, which is £28.8m. Total to investor £36.8m. Common gets £43.2m.
Participation shifts value from common to preferred at every exit above the preference. It continues until conversion would pay more, or a cap stops it.
Model 3: Participating with a 2x cap
Rule: participation continues until the investor hits a total of 2x the original, which is £16m. After that, participation stops, or the investor converts to common if that pays more.
- £6m exit: investor gets £6m, common £0.
- £20m exit: start with £8m preference, £12m remains. Participation would give £4.8m, total £12.8m, which is below the £16m cap. But the term says participation can continue until £16m total. Since only £12m remains, the investor cannot reach £16m, so they take £12.8m and common gets £7.2m. Now compare to a cap condition at this value: no further cap effect.
- £40m exit: preference £8m, £32m remains. Participation would add £12.8m, total £20.8m, which is above the £16m cap. The cap binds at £16m, so investor takes £16m. Compare with conversion as common, which would pay £16m. The investor is indifferent at £40m.
- £80m exit: the cap would pay £16m. Conversion as common pays £32m, which is higher. The investor converts and gets £32m. Common gets £48m.
To keep it crisp: the cap limits the investor’s total from preference plus participation to £16m, unless conversion pays more.
Side‑by‑side results and breakpoints
Here is a clean comparison for the base case.
| Exit Value | Model 1: Non‑Part Investor | Model 1: Non‑Part Common | Model 2: Part Investor | Model 2: Part Common | Model 3: Cap 2x Investor | Model 3: Cap 2x Common |
|---|---|---|---|---|---|---|
| £6m | £6.0m | £0.0m | £6.0m | £0.0m | £6.0m | £0.0m |
| £20m | £8.0m | £12.0m | £12.8m | £7.2m | £12.8m | £7.2m |
| £40m | £16.0m | £24.0m | £20.8m | £19.2m | £16.0m | £24.0m |
| £80m | £32.0m | £48.0m | £36.8m | £43.2m | £32.0m | £48.0m |
Breakpoints in words:
- Non‑participating switches at £20m, where common value equals the £8m preference.
- Participating without a cap always pays more to the investor than non‑participating until conversion beats the combined take. Common starts to gain later.
- With a 2x cap, the cap binds between mid and high exits. At £40m the cap forces the investor to stop at £16m, then at higher exits conversion takes over. Participation delays when common starts to see larger proceeds.
Build a simple exit waterfall in a spreadsheet
You can model one round or many rounds with the same structure. Keep the flow strict. Totals must always match the exit value.
Inputs to collect before you model
- Total exit value
- Sale costs and taxes if known
- Debt to repay
- Each round’s original investment, ownership, and preference multiple
- Participation flag for each series
- Cap multiple if participation applies
- Seniority rules, stacked by series or pari passu
- Any accrued dividends
- Option pool size
- Any carve‑out plans for management in low exit cases
Calculate the preference stack and breakpoints
- Order series by seniority. If pari passu, group them in the same tier.
- For each series, compute the preference amount: original investment times the multiple. Add accrued dividends if they sit in the preference. For capped participation, keep the cap value as original investment times cap multiple.
- Sum the preferences to find the total stack.
- For each series, find the conversion breakpoint: preference amount divided by ownership. This tells you where conversion equals staying preferred.
- For participating with a cap, also note the exit value at which total to that series would hit the cap. This is the cap‑trigger exit for that series.
Allocate proceeds across scenarios
- Start with the exit value, subtract debt and transaction costs. Work with net proceeds.
- Pay senior preferences first up to their amounts. If proceeds run out, stop. No series below gets paid.
- For non‑participating series, compare preference to value as common. Allocate the higher path for that series. If conversion is better, that series joins common for the remaining splits.
- For participating series, pay 1x first, then share the remaining pro rata by ownership or by an agreed sharing rule until any cap is hit. When a cap hits, stop participation for that series and move the remainder to others.
- After all preferences and any participation are processed, allocate the remainder to common holders by ownership.
- Add a check that the sum paid to all holders equals the net proceeds.
Stress test edge cases and avoid errors
- Test low exits where proceeds do not cover preferences.
- Test mid exits where some series convert and others do not.
- Add cases with multiple stacked rounds and a pari passu tier.
- Include accrued dividends to see their effect on breakpoints.
- Validation checks to include:
- Total paid out equals net exit.
- No negative balances anywhere.
- Any conversion choice should never reduce a holder’s payout.
Negotiation tips for founders: fair terms in 2025
Market patterns shift, but a few guides hold up. Use clean structures and avoid surprises. Simple terms also help hiring.
Terms to ask for in early rounds
- 1x non‑participating preference
- Pari passu within the round
- Simple seniority across rounds, later series only if agreed
- No dividends or non‑cumulative dividends
- Clean conversion to common on a qualified IPO
- If an investor insists on participation, ask for a tight cap, such as 2x total return
What to avoid or cap tightly
- Multiples above 1x unless the price reflects it
- Participation with no cap
- Super senior new money that jumps the queue in later rounds
- Long preference stacks across many rounds
- If you must accept a trade‑off, cap participation and add a sunset after the investor reaches a set return
How preferences affect hiring and the ESOP
Large stacks can leave options out of the money for years. That makes offers harder to accept. To keep the team aligned:
- Right‑size the option pool for the next 18 to 24 months.
- Share a plain spreadsheet that shows outcomes under low, mid, and high exits.
- Consider a carve‑out plan that pays a small pool to the team at low exits.
- Keep terms simple so candidates can see their upside.
Sample term sheet language in plain English
- Liquidation Preference: 1x non‑participating.
- Participation: none.
- Cap: if participation applies, total return capped at 2x of original investment.
- Seniority: pari passu among shares of the same series. Later series senior only if agreed in writing.
- IPO: all preferred converts to common on a qualified IPO.
Common mistakes and quick FAQs
Short, direct answers help when you are under time pressure. Use this as a reference when you read a draft.
Costly modelling mistakes to avoid
- Forgetting transaction costs and debt
- Mis‑ordering seniority across series
- Ignoring caps or dividends that add to the stack
- Assuming pro rata rights change the preference order
- Failing to check that total payouts equal net exit proceeds
Do SAFEs and notes have liquidation preferences?
SAFEs usually convert into preferred at the next round, then they take on that round’s terms. Before conversion they usually do not have a preference. Convertible notes are debt until they convert, so they often sit ahead of equity on repayment.
Is 1x standard in 2025? What about the UK and US?
Yes. 1x non‑participating is the common baseline in 2025 for strong rounds in both the UK and the US. Participation shows up more in down rounds or higher risk deals. Caps are a common compromise when participation is required.
Quick checklist before you sign
- Do I understand the preference multiple for each series?
- Is participation present, and if so, is there a clear cap?
- How is seniority set, stacked or pari passu?
- What are the conversion breakpoints for each series?
- Do dividends accrue into the preference?
- Are there any deemed liquidation triggers?
- Does the spreadsheet waterfall tie to the term sheet and total to the exit value?
- How does the stack affect the ESOP and hiring?
- Are carve‑outs defined for low exits?
- Has legal counsel reviewed final language?
Conclusion
Liquidation preferences decide how exit money flows. 1x non‑participating is simple and fair in most healthy rounds. Participation shifts value toward investors, and caps limit that shift. Your job is to model the exits, spot the breakpoints, and pick the structure that aligns with your plan.
Build the spreadsheet waterfall, share it with your team, and ask counsel to review the final terms. Know your breakpoints, keep your cap table simple, and choose partners who match your goals.
Contact us for a FREE consultation at info@consultEFC.com.
