Preferred Economics in Venture Transactions

July 15, 2025  |  By

Venture investments provide startups with capital to support growth and product development, but the structure of these transactions also plays a pivotal role in balancing risk and reward between founders and investors. While valuations are often the focal point in financing rounds, liquidation preferences frequently shape the final economics of an exit. [1] These provisions determine who gets paid, in what order, and how much, often with payouts that differ meaningfully from headline valuations.

The sections below break down the most common approaches to structuring liquidation preferences and examine how specific terms affect founder equity and investor returns. We also take a closer look at how these rights are typically negotiated in venture financings.

Liquidation Multiple

A liquidation multiple determines how much an investor receives before common stockholders in an exit scenario. It is typically expressed as a multiple of the investor’s original investment amount and serves as a baseline protection mechanism.

  • 1x liquidation multiple: The most common structure in early-stage venture financings, this entitles investors to receive their full investment amount before common stockholders receive any proceeds. A 1x multiple provides downside protection while preserving alignment in upside scenarios where investors are more likely to convert to common.
  • Greater than 1x multiple: Some investors negotiate a 1.5x, 2x, or even higher multiple— particularly in down markets, bridge rounds, or distressed situations. These enhanced rights are often requested in situations involving increased risk since the prior round or longer projected holding periods. From a founder’s perspective, however, multiples exceeding 1x can significantly diminish exit proceeds, even in moderately successful outcomes. In some cases, the multiple may step down or be eliminated if the company raises a future round at a specified valuation. These corrective incentives can help bridge valuation gaps in the short term and align long-term incentives.

Non-Participating vs. Fully Participating vs. Capped Preference

Before any exit proceeds are distributed to founders and employees, investors typically recover their initial investment through liquidation preferences. The specific terms of these rights can meaningfully affect founder outcomes and investor returns.

  • Non-participating: Investors with a non-participating preference receive the greater of (i) their liquidation preference (e.g., 1x their original investment) or (ii) the amount they would receive if they converted into common stock. This structure avoids “double-dipping” and tends to be more founder-favorable, especially in high-exit scenarios. However, in lower or flat exits, investors still maintain downside protection.
  • Fully participating: This allows investors to first receive their full liquidation preference and then participate pro rata in the remaining proceeds. It strongly favors investors and can leave common stockholders with limited proceeds, even in modest exits. Similar to an increased liquidation multiple or offering warrant coverage, providing a participation right can be used to bridge the gap between disagreements in a company’s valuation.
  • Capped participation: This less dilutive alternative to full participation allows investors to receive their liquidation preference and share in the remaining proceeds—but only up to a negotiated cap (typically expressed as a multiple, such as 2x total return). Once that cap is reached, investors must convert to common to share in further upside. This often serves as a compromise to continue incentivizing founding teams while still offering investors additional upside beyond basic downside protection.

To illustrate how these preferences work in practice, the examples use a simplified cap table:

  • Investor: $1M investment for 20% ownership ($5M post-money valuation)
  • Founder: 80% ownership held entirely in common stock

Each table below shows how proceeds are distributed between the two parties across a range of exit valuations.

Total Exit: $900,000 (loss)

 

Total Exit: $2,500,000 (down)

Total Exit: $5,000,000 (flat)

Total Exit: $7,500,000 (moderate; 1.5x valuation increase)

Total Exit: $15,000,000 (high; 3x valuation increase)

Seniority and Stacking of Liquidation Preferences

While liquidation preferences establish the priority of preferred stock over common, preferences can be stacked across multiple financing rounds to determine the order of payout among different rounds of investors.

  • Pari Passu vs. Seniority: When different series of preferred stock are treated pari passu, the investors share exit distributions proportionally, regardless of investment round. In a senior-subordinated structure, later investors may have higher priority, meaning their preference is paid before earlier investors.
  • Series vs. Sub-Series Priority: It’s common for Series A shares to rank senior to earlier rounds, such as Series Seed, meaning Series A investors are paid first in a liquidation. However, within a single financing round, particularly with “extensions” or staged seed raises involving multiple closings (such as Seed-1 through Seed-6), priority is often less consistent. Some companies designate all sub-series as pari passu, while others assign seniority based on the timing of investment, negotiated terms or valuation.

Additional Considerations

Beyond baseline preference terms, many venture deals include customized or blended structures that shape economics in more nuanced ways.

  • Interplay Between Multiples and Seniority: Liquidation multiples and seniority often work in tandem, particularly in stacked rounds. Later-stage investors with senior preferred stock carrying a 2x multiple (or greater) can receive most or all of the exit consideration before junior investors see any payout.
  • Performance-Based Preferences: Some investors may set a high liquidation multiple or participation cap that decreases if the company raises its next financing above a target valuation or if certain revenue or EBITDA targets are met.
  • Blended Participation Structures: Similarly, investors might negotiate for hybrid participation structures where participation rights vary based on exit timelines or performance thresholds, rewarding quicker outcomes but adding complexity to future modeling.
  • Convertible Instruments and Subordinate Parallel Series: Lead investors may require convertible notes or SAFEs to convert into a shadow series of preferred stock that ranks junior to the new investors’ shares. This ensures that new money investors retain priority in an exit, subordinating earlier investors—who generally invested with greater risk. These structures not only require material cooperation from the convertible holders, but also can significantly impact early investor returns, particularly when coupled with aggressive seniority stacking.

Founders and investors should model multiple exit scenarios to understand how liquidation terms affect outcomes. This helps ensure alignment with growth strategy and preserves meaningful incentives.

Endnotes

[1] We represent one fund client who is fond of saying: “I can structure around any valuation.”

Posted in: Funding & Capital Raising

About the Author(s)

Bobby Gojuangco

Bobby Gojuangco is an attorney at Vela Wood. He focuses his practice in the areas of venture financing, M&A, and taxation.

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