Liquidation Preference
Liquidation preference is a term that determines how proceeds are distributed to investors before common shareholders in a liquidity event.
Allocator relevance: A key driver of realized outcomes in venture—terms can materially change returns even if valuation growth looks strong.
Expanded Definition
Liquidation preference defines who gets paid first and how much, typically expressed as a multiple of invested capital (e.g., 1x) and whether it is participating or non-participating. Preferences stack across rounds and can create complex payout waterfalls. In downside exits, preferences can wipe out common and lower-priority investors; even in moderate outcomes, preferences can compress returns.
Allocators evaluating venture managers care because term discipline impacts DPI and net outcomes, not just paper marks.
How It Works in Practice
In an acquisition or liquidation event, proceeds flow through the preference stack, then to common. Term sheet specifics (participation, caps, seniority, conversion) determine payouts.
Decision Authority and Governance
Managers negotiate term sheets and approve rounds. Governance should ensure consistent term discipline and avoid accepting structures that distort incentives or create misalignment between stakeholders.
Common Misconceptions
- 1x preference is always LP-friendly (participation matters).
- Preferences only matter in “bad exits.”
- Valuation alone determines returns.
Key Takeaways
- Terms can dominate outcomes when exits are modest.
- Preference structure and stacking matter.
- Discipline in term negotiation is part of underwriting quality