Borenius’ Tech Blog – Liquidation Preference: Mechanics, Variations, and Common Pitfalls

The liquidation preference is almost always 1x non-participating in seed rounds, isn't it? But if it isn't, or if it changes further down the road, as it often does, the clause that felt routine at the outset can quietly become the most important part of your cap table.

The liquidation preference determines who gets paid first, and how much, when the company is sold or its assets otherwise distributed to shareholders. In typical venture capital setups, investors hold preferred shares that rank ahead of the common shares held by founders and employees in any distribution waterfall. The standard formulation of 1x non-participating means that the investors take back their invested amount, and whatever remains goes to the common shareholders. The preferred shares carry a built-in conversion right whereby investors may elect to convert into common shares and participate in the proceeds pro rata alongside common shareholders, rather than taking the fixed preference amount. At a sufficiently high value exit, investors will convert, and everyone will share the returns pro rata. At a modest exit, investors recover their capital, and common shareholders receive whatever remains.

The non-participating preference may also come with variations of its own. Some venture capital investors ask for an accrued preferred return on top of the 1x non-participating preference, typically between three and eight per cent. These accrued returns add a compounding layer to the waterfall: if the preference carries an eight per cent annual return, a five-year holding period adds roughly 47 per cent to the preference stack. Across multiple rounds, each carrying its own accrued return, the cumulative effect can dramatically erode the value of common shares. This is especially damaging if employees have participated in a management incentive plan by investing their own savings, which is common in later-stage buyout-backed companies, and equally relevant where there has been a tax-exempt employee share issuance. Having such a compounding layer in the waterfall means that the accrued preference return may eat all of the value of the common shares even with a modest increase in overall valuation.

Another point that is often overlooked when drafting the non-participating mechanism (largely because it is not caught by various Series Seed templates), is how the waterfall should treat distributions made before the final exit or liquidation. Consider, for instance, dividends paid out of profits, or proceeds distributed following a partial exit. In VC-backed companies these are relatively rare, but as holding periods lengthen, interim distributions may become increasingly relevant. The underlying idea behind the waterfall is that proceeds already paid out are netted off the investors' liquidation preference entitlement, so that their preference at exit is reduced accordingly. Without explicit drafting to this effect, the non-participating model may effectively enable investors to recover the same amount twice. Thought should also be given to when the liquidation preference even applies upon exit, as there are materially different outcomes in how exit proceeds are allocated between preferred and common shareholders depending on whether the liquidation preference applies to a full exit only or also to a partial exit.

After grasping the various nuances of VC liquidation preference, a full mind reset is needed when working with buyouts or certain growth investors. In a buyout structure, the waterfall typically comprises preference shares, which function effectively as shareholder loans carrying a fixed or PIK return, and common equity sitting below them. In the Finnish market, all shareholders typically hold the same instruments, but management and founders are allocated a proportionally larger share of the common equity relative to their capital contribution. This disproportionate allocation functions as sweet equity, concentrating a larger share of both upside and downside in the hands of founders and management.

Moving between a VC and buyout waterfall without adjusting the underlying framework is one of the more common sources of error in exit waterfall modelling. The terminology is familiar. The economics of the preference stack are not.

If you have any questions regarding this blog post, don't hesitate to contact our Venture Capital & Growth Equity team.