Liquidation preferences (aka liqprefs) entitle the investor to recuperate the amount of their original investment before any of the sale proceeds are distribute to other shareholders.

This is meant for their ‘downside protection’ and this is what liqprefs are primarily designed for. It is very common and also understandable to some extent. But it can also create conflicts of interest between founders and investors.

There are roughly 2 forms of liqprefs: non-participating and participating. Non-participating is *either/or* while participating is *and/and*. And this is important to realize. With a non-participating liqpref, an investor is entitle to either the amount he/she invested OR its share of the exit proceeds (whatever is more). With a participating liqpref an investor will get his/her amount back PLUS its share of the remainder of the exit proceeds. For this reason, this is also called a double dip.

Why are participating liqprefs a problem?

For founders it can become demotivating, and early investors may end up shooting themselves in their own foot. If you get in early, you set the trend. Every follow-on investor will demand at least the same, and perhaps more. In a new investment round, liqprefs from the last round usually take precedence over those from the previous round. So when it comes to an exit, founders, employees with common shares as well as early investors are hit by the investors of the latest rounds holding participating liqprefs. If the exit proceeds are not as good as hoped, there will nothing be left for them because all will go to the later investors.

You can imagine that the advise of Sjoerd Mol and myself in our Startup Funding Book is: “These should be at the top of your list of conditions you don’t want in your term sheet.”

For more practical advice about fundraising and dealterms as well as insights from top VCs and founders, order our book anywhere (e.g. via bol.com, Amazon or your local bookstore).