Term sheet
Liquidation preference
The clause that decides who is paid first when the company is sold. At modest exit values it matters more than the valuation.
A liquidation preference says that, when the company is sold or wound up, preferred stockholders are paid a set amount before common stockholders receive anything. "Liquidation" in a term sheet almost always includes a sale or merger of the company (a "deemed liquidation event"), not only a shutdown, so this clause decides how the proceeds of most exits are split. At high exit values it rarely matters; at modest ones it can decide whether founders and employees receive anything at all.
The four common variants
- 1x non-participating
- The investor receives the greater of (a) its investment back or (b) what its shares would receive if converted to common. The most common position in early-stage rounds.
- Participating ("double dip")
- The investor first receives its investment back, then also shares in what is left as if it held common stock. It never needs to convert.
- Capped participation
- Participating, but total proceeds (preference plus participation) are capped at a multiple of the investment, for example 3x. Above the point where converting pays more, the investor converts.
- Multiple (2x, 3x)
- The preference is a multiple of the investment. Combined with participation, it can take most of a modest exit.
Payouts at four exit values
An investor puts in $10 million for 25% of the company (2,500,000 of 10,000,000 shares); founders, employees and other common holders own the other 75%. Here is what the investor receives under each variant:
| Exit value | $8 million | $20 million | $60 million | $150 million |
|---|---|---|---|---|
| 1x non-participating | $8 million | $10 million | $15 millionconverts | $37.5 millionconverts |
| 1x participating | $8 million | $12.5 million | $22.5 million | $45 million |
| 1x participating, capped at 3x | $8 million | $12.5 million | $22.5 million | $37.5 millionconverts |
| 2x non-participating | $8 million | $20 million | $20 million | $37.5 millionconverts |
| For comparison: 25% as common | $2 million | $5 million | $15 million | $37.5 million |
And what is left for the common holders (founders, employees, angels holding common):
| Exit value | $8 million | $20 million | $60 million | $150 million |
|---|---|---|---|---|
| 1x non-participating | $0 | $10 million | $45 million | $112.5 million |
| 1x participating | $0 | $7.5 million | $37.5 million | $105 million |
| 1x participating, capped at 3x | $0 | $7.5 million | $37.5 million | $112.5 million |
| 2x non-participating | $0 | $0 | $40 million | $112.5 million |
Three things stand out:
- At a $8 million sale, below the amount invested, every variant hands the whole exit to the investor. The preference is downside protection first.
- Non-participating preferences stop mattering once the exit is large enough that converting pays more: here above $40 million for 1x ($10 million ÷ 25%), and above $80 million for 2x.
- Uncapped participation never stops mattering: at $150 million the participating investor still takes $7.5 million more than its 25% share.
Try other structures, including several series with different seniority, in the exit waterfall calculator.
Seniority across rounds
With more than one series of preferred, the charter also says who is paid first. The two common patterns are pari passu (all series share the available proceeds in proportion to their preferences) and standard seniority (the latest series is paid in full first, then the next). Seniority matters only when the exit is smaller than the total preference stack, but that is exactly when it matters most to the people below. Later investors often ask for seniority; earlier ones resist. Founders sit at the bottom either way.
How SAFEs and notes fit
- A post-money SAFE converts into a shadow series of preferred with the same preference terms as the new money, but its per-share preference is based on the SAFE price, so its preference equals what the SAFE holder paid, not its shares times the round price. YC's 2023 form update made explicit that a liquidation multiple on the standard preferred applies to the SAFE preferred too.
- Before conversion, a SAFE in a sale takes the greater of its money back or its as-converted amount, ranking with preferred stock. Convertible notes are debt and are paid before any preferred stock.
What to watch in a term sheet
- "1x non-participating" stated plainly. Participation or a multiple above 1x is a significant economic term; treat it as part of the price.
- The definition of a deemed liquidation event: which transactions trigger the preference.
- Seniority versus pari passu across series, and how future rounds will be treated.
- Cumulative dividends added to the preference: they quietly increase it every year.
- Management carve-outs in a low sale are negotiated at the time; they are not a substitute for sensible preference terms now.
Liquidation preferences are set out in the company's certificate of incorporation. In Delaware, the corporation law allows the charter to give a class or series of stock preferences on liquidation; the exact mechanics are in the charter wording, which your lawyer drafts from the term sheet.
Sources
- Model Legal Documents (term sheet, certificate of incorporation, investors' rights, voting and ROFR/co-sale agreements), National Venture Capital Association. Cited for structure; not reproduced.
- Delaware General Corporation Law, Title 8, Chapter 1, State of Delaware. Cited for facts.