Liquidation preferences mean even successful startups can be failures for investors, employees, and founders

I’ve seen a lot of founders bemoaning how they toiled for years to build a successful startup, sold the business for $200M, and walked away with…nothing?

How is it possible that a $200M acquisition could be a failure? There’s a simple answer — liquidation preferences.

Unless your startup is that rare runaway success where everyone walks away as millionaires, the liquidation preference rather than the valuation will determine the payouts to investors, employees, and founders. What seems like a minor detail is usually the most important term on the term sheet.

If you want an outcome where the last investor doesn’t eat the entire payout, instead of obsessing over valuations, fight tooth and nail over those liquidation preferences.

How Can a $100M Payout Leave Nothing for Me?

If you think everyone’s stock in the company is equal, you’re missing the reason why preferred shares are preferred and founder shares are common.

In a big acquisition or IPO, all shares convert to common. If you own 25% of the shares and the startup is acquired for $100M, you walk away with $25M. The CTO with options for 3% gets a check for $3M (minus the nominal cost of purchasing the shares at their value years ago.) An early investor like me who invested $1M to buy a 10% stake now has $10M. Hurray! Everyone leaves whistling a happy tune.

Now imagine you raised $50M from a big VC. If you agreed to a 1x liquidation preference, they’re guaranteed to get their $50M back before anyone else gets anything. Fair enough. But if you agreed to a 2x liquidation preference, they get the first $100M. Unless you exit at over $100M, they eat your entire lunch.

Exit at $115M? They get the first $100M, leaving $15M for everyone else. But if an earlier round of investors put in $10M with a 1.5x liquidation preference, they’ll get the remainder.

Depending on how much you raised at what liquidation preference, you might have $150M accounted for before common shareholders see a cent. Medium CEO 

Tony Stubblebine recently wrote how Medium had $225M in liquidation preferences (plus $37M in overdue loans that needed to be repaid), meaning any acquisition would’ve left nothing for the staff.

What the Heck is a Liquidation Preference?

One of the key terms in a venture investment, whether that’s via SAFE, convertible note, or preferred equity, is the liquidation preference.

The liquidation preference is the minimum guaranteed return. The default, hard-coded into the YC SAFE, is 1x, meaning investors get their money back before founders get their cut.

But larger liquidation preferences are common, especially at later stages. Late-stage investors are more like (or actually are) private equity than venture capital. By that point, the startup is already richly valued and the risk of total failure is low.

If a VC fund puts in $50M with a 2x liquidation preference, that means the first $100M in an acquisition goes to them before anyone else gets a cent.

Later-stage investors may be looking for a 2x return in 2 years rather than a 100x return in 10. So rather than fight over valuation, which affects the upside, they demand a high liquidation preference to guarantee an attractive minimum return.

The Waterfall Into Hell

Your startup has made it to Series C. Congratulations. You probably have a cap table that looks something like this:

  • pre-seed: $1M at $10M valuation, 1x liquidation preference
  • seed: $4M at $20M valuation, 1x liquidation preference
  • Series A: $10M at $50M valuation, 1.5x liquidation preference
  • Series B: $20M at $100M valuation, 1.5x liquidation preference
  • Series C: $50M at $150M valuation, 2x liquidation preference
  • Total raised : $90M
  • Total liquidation preferences: $150M

If the company is acquired for less than $150M, there will be nothing left for common shareholders.

Later rounds always get priority over earlier rounds. So if the company is sold at $100M or less, Series C takes it all. At $130M or less, Series B gets a 1.5x return on their investment as well. At $145M, Series A gets a 1.5x return.

At $149M and $150M, the seed and pre-seed investors like me who believed in your vision and put in that critical early cash to help you get off the ground are lucky to get their money back 10 years later. Oof. But better than not getting anything at all.

What starts as a waterfall can turn into a trickle, and all too often, into a dry riverbed.

Participating or Non?

What happens when your startup is acquired for $200M, safely above the total liquidation preferences? The answer depends on whether those liquidation preferences are participating or non-participating.

Non-participating means the investor gets the higher of the liquidation preference or converting their shares to common and taking their pro-rata amount with everyone else.

If all the liquidation preferences in the above example are non-participating, then all the shares will convert to common and each investor gets a portion of the $200M. Series C which owns 1/3 of the shares would get $66.7M.

The shareholdings after 5 rounds of funding (and topped up employee options pool) is impossible to calculate without a full cap table, but let’s assume common shareholders, including founders, still hold 1/3 of the shares. So they’d split $66.7M between themselves, too.

Participating liquidation preference means the investors get their liquidation preference first, then their shares convert to common and they participate in that pool, too.

In other words:

  • participating = liquidation preference and pro-rata
  • non-participating = liquidation preference or pro-rata (whichever is higher)

In our $200M acquisition example, if all the liquidation preferences are participating, $150M is handed out to investors off the top, then the remaining $50M is split according to shareholdings. The Series C shareholder would take home $100M + 1/3 of $50M or $116.7M.

The common shareholders, including the founders, would split 1/3 of the $50M remaining after liquidation preferences or $16.7M.

$66.7M or $16.7M — a huge difference in payout for those 3 little letters: “non”. It pays to pay attention to details.

Vulture Terms

Your startup is in trouble. Revenues fell last quarter. You need another infusion of cash to stay alive. New investors politely decline.

Your lead investor in the previous round steps up and says they’ll be your savior. They’ll put in another $25M to help you over the hump. They’ll do it at the same valuation as the last round. Woohoo! You’re incredibly grateful they’re not demanding a cram down or recap.

Then they send you the term sheet. Buried in the fine print is a 4x liquidation preference. Aargh. If you take it, you’ve just agreed to work for free until the day the business is sold (unless you can somehow sell the business for more than $100M.)

That sale might come sooner than you expect, though. If they can find a buyer for the business at $100M, a 4x return is a nice win for them. Sure, more is better for everyone, but not if it takes too long. Legally, as board members, they have a fiduciary duty to all investors. In reality, they’ll do what’s in their best interest and dare you to sue them.

A Bright Tunnel to the Other Side (for Key Employees Only)

The saving grace for founders to avoid complete disaster is often the retention pool.

Especially for early-stage startups, the product is only half-finished and the business synonymous with the founders. Without the founders and key employees, there is nothing of value to acquire.

So most acquisitions include a “retention pool.” That $200M headline number might be split between acquiring the stock for $175M and a separate $25M reserved for payouts to key employees over a 2 or 3 year earn-out.

Later investors get their liquidation preference. Key employees have an incentive to stay. Regular employees get to keep their jobs. The board, which usually consists of founders and later investors, will agree to the terms. Early investors like me get nothing, but nobody cries for us.

It’s not a great win for anyone, but it’s often the only viable option if the company isn’t growing fast enough to attract new investment.

Deal Terms Matter

Startup founders obsess over valuation. They see it as validation. They see it as a numerical score of their self-worth. It’s not.

Because unless your startup will be in the tiny, tiny minority that is acquired or does an IPO at a valuation far above that of the last funding round, the term that matters the most is the liquidation preference.

Anything more than 1x non-participating is worth fighting hard over if you want to protect yourself and earlier investors.

For most founders (and investors and employees), it’s the liquidation preference that will make the most the difference in the return that they’ll receive in the end.