TL;DR: A liquidation preference determines the order and amount in which investors are paid if a company is sold, wound down, or liquidated. It gives preferred shareholders the right to recover their investment before common shareholders receive anything.
A liquidation preference is a term in an equity investment that protects the investor's downside. In a liquidation event such as a sale or wind-down, holders of preferred shares are paid out before holders of common shares, up to a defined amount. The most common form is a 1x non-participating preference, meaning the investor first gets back one times their investment, then participates no further.
Participating preferences, by contrast, let the investor recover their preference and then also share in the remaining proceeds, which is more favourable to the investor and more dilutive to common shareholders. Multiples above 1x increase the investor's protected return.
A liquidation preference governs priority among equity holders. It sits beneath debt in the broader order of repayment: lenders, both senior and subordinated, are generally repaid before any equity holder, preferred or common. Understanding both layers, debt seniority and equity preferences, gives founders the full picture of who gets paid in what order in a downside scenario.
What is a 1x non-participating preference? The investor receives their original investment back before common shareholders, and then does not participate further in the remaining proceeds. It is the most founder-friendly standard.
Does debt rank above liquidation preferences? Generally yes. Debt is typically repaid before equity of any class, so a liquidation preference applies to what is left after lenders are satisfied.
Related terms: Capital Stack · Senior Debt · Subordinated Debt · Equity Dilution
