A liquidation preference is the right of an investor to be paid back before the other shareholders when the business is sold or wound up. It’s attached to preference shares and written into the company’s articles of association, or in the US into its certificate of incorporation. A 1x preference means the investor gets back what they put in before the other shareholders are paid.
A standard 1x preference makes no difference to the founders on a sale above the valuation the investor came in at, but on a smaller sale it can leave them with far less than their percentage suggests.
I’ve raised £250m+ for my own companies and funded more than 750 businesses with over £1bn, so I’ve seen preferences as a founder and as an investor.
What a Liquidation Preference Is
Despite the name, a liquidation preference mostly matters on a sale. The articles usually treat a sale of the company, or of all or most of its assets, the same way as a winding up, so the preference applies to the money from the sale. Lenders and other creditors are paid before any shareholder in either case, so the preference only decides how the money left for shareholders is shared out.
An investor wants a preference because they paid a price per share based on a valuation of the business, while the founders often paid only the nominal value for theirs. Without one, a sale below that valuation means the investor loses part of their money while the founders still receive a large sum.
The terms that describe a preference are:
- The multiple. 1x returns the amount invested. 2x returns double it.
- Participation. Whether the investor also shares in what’s left after their preference is paid.
- Seniority. Where it ranks against the preferences of investors from other rounds.
1x Non-Participating vs Participating
| 1x non-participating | 1x participating | |
|---|---|---|
| What the investor gets | Their money back or their percentage of the sale, whichever is higher | Their money back, then their percentage of what’s left |
| On a sale above the post-money valuation | Their percentage, the same as every other shareholder | More than their percentage |
| Where it’s usually seen | The usual position in early-stage venture rounds | Rounds where the investor has more negotiating power, or the business has little to show yet |
With a non-participating preference, the investor has to choose. They take their money back, or they convert their preference shares into ordinary shares and take their percentage of the sale. They take whichever pays more, so above a certain sale price the preference stops mattering. That point is the amount invested divided by the investor’s percentage.
A participating preference gives the investor both. They take their money back first and then share in everything left, as if they’d converted as well. It pays the investor more than their percentage at every sale price, although the gap narrows as the sale price rises.
Multiples. A 2x or 3x preference returns that multiple of the money before anyone else is paid. On a non-participating 2x preference, the investor only converts once their percentage is worth more than double their money.
Capped participation. Some term sheets let the investor participate until they’ve received a set total, often 2x or 3x their money. Above that, they get the cap or convert to their percentage, whichever is higher.
Exit Waterfall: A Liquidation Preference Example
An exit waterfall sets out who gets what from a sale, in the order they’re paid. Say an investor puts £2m into a business at a £6m pre-money valuation. The post-money valuation is £8m and the investor owns 25%. The founders and the other ordinary shareholders own the other 75%. There’s no debt to repay.
Each cell shows what the investor and the founders receive, in that order.
| Sale price | No preference | 1x non-participating | 1x participating | 2x non-participating |
|---|---|---|---|---|
| £4m | £1m / £3m | £2m / £2m | £2.5m / £1.5m | £4m / £0 |
| £8m | £2m / £6m | £2m / £6m | £3.5m / £4.5m | £4m / £4m |
| £16m | £4m / £12m | £4m / £12m | £5.5m / £10.5m | £4m / £12m |
| £40m | £10m / £30m | £10m / £30m | £11.5m / £28.5m | £10m / £30m |
At £4m, the 1x non-participating investor takes their £2m back, because 25% of £4m is only £1m. The founders get the other £2m, which is 50% of the sale for a 75% holding. Under a 2x preference the investor takes all £4m and the founders get nothing.
At £8m, the post-money valuation, a non-participating investor gets the same from either choice, so the founders get their full 75%. A participating investor takes £2m and then 25% of the remaining £6m, so £3.5m in total, and the founders get £4.5m, or 56% of the sale.
At £40m, the non-participating preferences make no difference. The participating investor takes £2m plus 25% of £38m, so £11.5m, and the founders get £28.5m. As a share of the sale, the participating preference leaves the founders 38% at £4m, 56% at £8m, 66% at £16m and 71% at £40m, against the 75% they own.
A 2x non-participating preference stops mattering at £16m, because 25% of £16m is £4m, double the money. If the participating preference had a 3x cap, the investor’s total would hit £6m at an £18m sale, stay at £6m until 25% of the sale is worth more, at £24m, and convert above that.
Stacking Preferences Across Rounds
When a company raises more than once, each round usually comes with its own preference. The founders receive nothing until the total of all the preferences has been paid, or until the sale is big enough that the investors convert.
How the preferences rank against each other is called seniority:
- Standard, or stacked. The latest investor is paid first, then the one before, and so on.
- Pari passu. All the preference holders rank equally and share the money in proportion to their preferences.
Say the same company raised £1m at seed at a £4m pre-money valuation, so the seed investor owned 20%, and then £3m at Series A at a £9m pre-money valuation. After the Series A, the Series A investor owns 25%, the seed investor 15% and the founders 60%. Both have 1x non-participating preferences, so £4m of preferences sit ahead of the founders.
| Sale price and ranking | Series A | Seed | Founders |
|---|---|---|---|
| £3m, Series A senior | £3m | £0 | £0 |
| £3m, pari passu | £2.25m | £0.75m | £0 |
| £6m, either ranking | £3m | £1m | £2m |
| £20m, either ranking | £5m | £3m | £12m |
Seniority only changes how the money is split between investors when the sale is worth less than the total preferences. For the founders, the number that matters is the total. At £6m they get £2m, which is 33% of the sale for a 60% holding. With no preferences they’d have had £3.6m. At £20m both investors convert and everyone gets their percentage.
What’s Market in the UK
Many early UK rounds have no liquidation preference at all. Investors claiming tax relief under SEIS or EIS need full risk ordinary shares that carry no special rights to the company’s assets, and the SEIS rules say the same. A preference is a special right to the company’s assets, so an angel round raised under the schemes is usually all ordinary shares.
Preferences come in when a venture fund leads a priced round. In a round that mixes scheme investors and a fund, the scheme investors hold ordinary shares and the fund holds preference shares, and the solicitors check the share rights against the scheme rules before the shares are issued. Lawyers often start from the UK Private Capital model documents for a Series A.
In early-stage venture rounds, in the UK and in the US, Canada, Australia, Singapore and the UAE, a 1x non-participating preference is the usual starting point. Participating preferences, multiples above 1x and stacked seniority are usually treated as aggressive, and tend to appear when the investor has more negotiating power, such as in a round at a lower valuation than the last.
Once the preference is in the articles, it’s a class right. Under section 630 of the Companies Act 2006, changing it needs whatever the articles provide for, or, if they say nothing, the consent of holders of three-quarters of that class of shares.
Negotiating Liquidation Preferences
The preference is agreed in the term sheet, alongside the valuation and the other rights. The points that can be negotiated include:
- The multiple. 1x rather than anything higher.
- Participation. Non-participating, or a cap on participation if the investor insists on it.
- Seniority. Pari passu with earlier investors, rather than ranking ahead of them.
- What’s added to it. A cumulative dividend builds up every year it isn’t paid and is usually added to the preference, so the amount paid first keeps growing.
A preference is often traded against the valuation. Say the investor offers £2m at an £8m pre-money valuation with a 1x participating preference, instead of £2m at £6m with a 1x non-participating one. The higher valuation gives the investor 20% instead of 25%. On a £16m sale, the founders get £12m with the lower valuation and £11.2m with the higher one, because the participating investor takes £2m plus 20% of £14m. The higher valuation only leaves the founders better off on a sale above £32m.
The investor pitch deck and the investment memorandum set out the plan the investor is backing. The preference decides who is protected if that plan ends in a smaller sale than everyone hoped, and running the waterfall at several sale prices shows what each version is worth to the founders in pounds.
How to prepare for a negotiation like this and run it is what I teach in the Negotiation Masterclass.
FAQs
What is a 1x liquidation preference?
A 1x liquidation preference means the investor gets back the amount they invested before other shareholders are paid on a sale or winding up. If it’s non-participating, they take that or their percentage, whichever is higher.
What does participating preferred mean?
Participating preferred means the investor gets their money back first and then also shares in what’s left in proportion to their holding. It’s the US name for a participating preference.
Does a liquidation preference apply when a company is sold?
Yes, usually. The articles normally treat a sale of the company, or of all or most of its assets, as a liquidation event.
Do SEIS and EIS investors get a liquidation preference?
No. SEIS and EIS shares have to be full-risk ordinary shares with no special rights to the company’s assets, so investors claiming the relief can’t hold shares with a liquidation preference.
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This is general information on how liquidation preferences work and isn’t legal advice. A solicitor who handles investment rounds should review the share rights before they’re agreed.
