You’ve just received a term sheet. The headline valuation looks great — $10 million pre-money, $2.5 million investment, and you’re only giving up 20% of the company. Time to celebrate, right?
Maybe. But buried in the economics section of that term sheet is a clause that will fundamentally shape how much you actually take home when your company exits. It’s called the liquidation preference, and most first-time founders don’t fully appreciate what it means until the numbers are staring them in the face at a trade sale.
What Is a Liquidation Preference?
A liquidation preference is a contractual right that guarantees preferred shareholders — typically your venture capital investors — get paid before ordinary shareholders in a “liquidity event.” That includes a sale of the company, a merger, or a winding up. In practice, the most common trigger is a trade sale or acquisition.
The core idea is straightforward: the investor put in real money at a point of high risk, and they want a floor on their return. If the company sells for less than expected, the investor gets their money back before the founders and employees see anything.
Under Australian law, the Corporations Act 2001 (Cth) gives companies broad flexibility to create different classes of shares with different rights (section 254A). That’s what makes preference shares — and the liquidation preferences attached to them — possible. The specific rights are defined in the company’s constitution and the shareholders’ agreement, not in the statute itself. This means the terms are almost entirely negotiable, which is exactly why you need to understand what you’re agreeing to.
The Building Blocks
Every liquidation preference has three components that interact to determine your payout at exit.
1. The Multiple
The multiple defines how much the investor gets back before anyone else is paid. A 1x liquidation preference means the investor receives their original investment amount first. If they invested $2.5 million, they get $2.5 million off the top of any exit proceeds.
A 1x non-participating preference is the market standard in Australia, the US, and most developed venture markets. It’s considered founder-friendly because the investor is simply getting their money back — no more, no less — before choosing whether to convert to ordinary shares and participate alongside everyone else.
But multiples can go higher. A 2x preference on a $2.5 million investment means $5 million comes off the top before common shareholders see anything. A 3x preference means $7.5 million. These higher multiples were uncommon during the bull market of 2020–2021 but have resurfaced as investors seek greater downside protection in tighter markets.
2. Participation Rights
This is where it gets consequential. There are two flavours:
Non-participating preferred. The investor chooses the better of two options: (a) take their liquidation preference amount, or (b) convert their preferred shares to ordinary shares and take their pro-rata share of the total exit proceeds. They can’t do both. This is often called a “simple” or “straight” preference, and it’s the most founder-friendly structure.
Participating preferred. The investor gets their liquidation preference and then participates alongside ordinary shareholders in the remaining proceeds on a pro-rata basis. This is sometimes called “double-dipping” because the investor effectively gets paid twice — first as a preferred shareholder, then as if they were an ordinary shareholder too.
The impact is material. Consider our $2.5 million investment at a $12.5 million post-money valuation (20% ownership). If the company sells for $20 million:
- Non-participating 1x: The investor chooses between $2.5 million (preference) or 20% of $20 million ($4 million). They’ll convert, taking $4 million. Founders and other ordinary shareholders split the remaining $16 million.
- Participating 1x: The investor takes $2.5 million off the top, then takes 20% of the remaining $17.5 million ($3.5 million). Total: $6 million. Founders split $14 million instead of $16 million.
That $2 million difference comes directly out of the founders’ and employees’ pockets. And it compounds across multiple rounds with multiple investors.
3. Seniority
When a company has raised multiple rounds, each with its own liquidation preference, the question of seniority — who gets paid first among the preferred shareholders — becomes critical.
Standard (pari passu): All preferred shareholders are paid simultaneously, proportional to their respective preferences. This is the most common structure.
Stacked (senior): Later-round investors get paid before earlier-round investors, who get paid before common shareholders. A Series B with seniority over Series A means that in a modest exit, the Series A investors might get nothing, let alone the founders.
Stacked preferences are particularly dangerous because they can create scenarios where founders receive zero even when the company sells for a meaningful sum. If a company has raised $15 million across three rounds with stacked 1x preferences, the first $15 million of any exit goes to investors in reverse order of investment — and that’s before participation rights even come into play.
The Modest Exit Problem
Liquidation preferences rarely matter in blockbuster exits. If your company sells for 20x the invested capital, the preference is irrelevant — everyone converts to ordinary shares because the pro-rata payout exceeds the preference.
Where preferences bite is in the modest exit — the outcome that is, statistically, far more likely. If a company has raised $8 million in total with 1x participating preferences across two rounds, and it sells for $12 million, the investors take $8 million off the top, then participate in the remaining $4 million proportionally. Depending on their combined ownership percentage, founders and employees might split $2–3 million on a $12 million exit. That’s a sobering number.
This dynamic creates a zone of misaligned incentives. Founders might want to accept a reasonable acquisition offer, but investors with participating preferences have less incentive to agree because the preference structure already guarantees them a disproportionate share of modest outcomes. They’d rather push for a larger exit or nothing at all.
What Founders Should Negotiate
You probably can’t avoid a liquidation preference entirely — it’s standard in priced rounds, and for good reason. But you can negotiate the terms that determine whether the preference is fair or punitive:
- Insist on 1x non-participating. This is the market standard. Anything above 1x should require a compelling justification from the investor, and participating preferences should be resisted unless you’re extracting a significantly higher valuation in return.
- If you accept participation, negotiate a cap. A capped participation right limits the investor’s total return through the preference mechanism. A common cap is 2x or 3x the original investment. Once the investor’s total payout (preference plus participation) hits the cap, they convert to ordinary shares. This limits the double-dipping while still giving the investor enhanced downside protection.
- Watch the seniority stack. Push for pari passu treatment across all preferred series. If a later-round investor demands seniority, understand that this directly harms your earlier investors — who may become less supportive allies as a result — and dramatically increases the exit value needed for founders to see meaningful returns.
- Model the exit waterfall. Before signing any term sheet, build or have your lawyer build a simple waterfall model showing what each class of shareholder receives at different exit values ($10 million, $25 million, $50 million, $100 million). This single exercise reveals more about the real economics of a deal than any amount of valuation discussion.
The Bottom Line
A high valuation on a term sheet with aggressive liquidation preferences is not necessarily a good deal. A $20 million valuation with 2x participating preferred can leave founders worse off than a $15 million valuation with 1x non-participating.
The headline number gets the press release. The liquidation preference determines the bank transfer. Make sure you understand both before you sign.
If you’re negotiating a term sheet and want to understand exactly how the liquidation preference affects your payout at exit, get in touch. We help Australian founders model exit waterfalls and negotiate preference terms that keep incentives aligned.
For related reading, see our guides on co-founder agreements and secondary sales of startup shares — both areas where understanding your share structure is critical.
