Liquidation preferences dictate how proceeds are distributed to shareholders when your company is sold, merged, or liquidated.

It’s a way for investors to protect their capital by making sure they’re paid back before common shareholders - typically the founders and employees holding ordinary shares - receive any payout.

At a high level, there are two components of a liquidation preference:

1. Participation (Participating vs. Non-participating).
2. The Multiple (1x, 2x, etc.)

Here’s what each element means.

With a participating liquidation preference, preferred shareholders receive their original investment back plus a percentage of the remaining proceeds after the original investment has been repaid.

A non-participating liquidation preference means that the investor will receive whichever amount is higher between the 1x investment amount and their pro rata share of the remaining proceeds.

Let’s bring this to life with an example.

Imagine an investor invests £2M, and holds 50% of all shares in a company. Here’s a breakdown of how much they would get depending on their liquidation preference and the total exit proceeds.

*Reminder: With a non-participating preference the investor will receive the 1x investment amount or the pro rata proceeds, whichever is higher.

In 2024, 87% of preference shares in the UK were non-participating, down slightly from 89% in 2023¹. This suggests that even in a difficult market, non-participating preference shares are the norm.

The second important part of liquidation preferences is the liquidation multiple.

A liquidation multiple is the multiple of the investor's initial investment that they are entitled to before ordinary shareholders receive any proceeds. For instance, a 1.0x liquidation preference means the investor will get their original investment back, while a 2.0x liquidation preference means they get twice their original investment before any other distributions are made.

In 2024, 97% of non-participating shares had a 1x multiple², which is generally considered founder friendly.

Participating preference shares often have multiples as well, and in 2024, 84% of participating preference shares³ carried a 1.0x multiple.

Because they define the hierarchy of payments for shareholders, liquidation preferences create a "priority stack,"

There are two main types of priority structures:

1. Standard priority: Where preferred shareholders are paid first, followed by ordinary shareholders.
2. Pari passu: Where investors across different rounds are treated equally and receive proceeds proportional to their investment amounts.

In 2024, 72% of non-participating shares⁴ followed the standard priority stack. This emphasises that both founders and investors need to carefully review how much money could be left once others have claimed their liquidation preference.

For founders, especially in early funding rounds, it’s essential to negotiate liquidation preferences to avoid unfavourable terms that can limit your return on exit.

Here’s what you should keep in mind:

1. A 1.0x multiple is market standard: A 1.0x non-participating liquidation preference is often the most balanced option. It ensures investors are protected but doesn’t disproportionately affect ordinary shareholders' returns.
2. Avoid participating preferences: Participating preferences allow investors to "double dip" into the exit proceeds, which can severely reduce your return. Negotiate for non-participating preferences to limit its impact.
3. Consider future rounds: Each new round of funding may bring additional investors with their own liquidation preferences. Be mindful that these new preferences could stack on top of earlier ones, reducing what’s left for common shareholders, including you and your team.
4. Include a cap table and exit waterfall: When negotiating with investors, ensure your term sheet includes a cap table and an exit waterfall. A cap table outlines the ownership percentages for each shareholder class, and an exit waterfall provides a detailed analysis of how the proceeds from an exit will be distributed. This will help you visualise the financial outcomes for you and your team under different exit scenarios, especially when liquidation preferences are in play.
5. Ensure alignment on valuation: Sometimes investors push for higher liquidation multiples to protect their downside. If they insist on a high liquidation preference (e.g., 2x or higher), it could indicate a mismatch in expectations about the company’s exit valuation. In such cases, try negotiating for a lower valuation or reducing the liquidation multiple to balance risk and reward.

In conclusion, liquidation preferences are critical to understand and negotiate properly, they will determine how much return you, your employees, and your investors receive upon an exit. By focusing on keeping liquidation multiples reasonable, avoiding participating preferences when possible, and ensuring clear communication with your investors, you can create a fair structure that benefits all parties involved while maximising your company's long-term success.