What liquidation preference does
Liquidation preference sets the payout order at an exit (sale, liquidation). With preferred stock, investors often have a preference claim ahead of common shareholders.
1* non-participating in plain English
- Investors typically receive the greater of: (a) their preference amount (often investment * 1*) or (b) what they'd receive if they convert to common.
- At low exit values, preference often dominates; at high exit values, conversion often dominates.
Convert or take preference: the decision rule
- Preference payout ~= investment * preferenceMultiple (for 1x, it is the investment).
- As-converted common payout ~= ownershipPercent * exitValue (ignoring other classes).
- Break-even exit value ~= preferenceAmount / ownershipPercent.
A practical waterfall checklist
| Step | Question | Why it matters |
|---|---|---|
| 1 | Who is senior to whom- | Seniority decides payout order |
| 2 | What is each class's preference multiple- | 1x vs 2x changes low-exit outcomes |
| 3 | Is it participating or non-participating- | Participation adds extra upside after preference |
| 4 | When can/should investors convert- | Conversion flips the payout regime |
Variants to watch (terms that change outcomes)
- Participating preferred: investors may get preference plus a share of remaining proceeds.
- Multiple classes: stacked preferences can wipe out common at moderate exits.
- Capped participation: participation may stop after a cap (e.g., 3x total).
- Carve-outs and management incentives: proceeds may be allocated before common (deal-specific).
Common mistakes
- Ignoring multiple classes and seniority (stacked preference waterfall).
- Ignoring participation features (participating preferred is different).
- Using ownership % that doesn't match the cap table at exit.
- Forgetting option pool increases or convertible conversions that change ownership at the priced round.