Liquidation preference is a right commonly found in terms sheet.
It provides the investor the right to receive their investment back and then the remaining profits are distributed pro rata to other stakeholders.
It’s often expressed in multiples such as 1X, 2X, or 3X.
This means the investors with those rights will receive 1X their investment before distributing the remaining exit funds based on their equity-based division.
Liquidation preferences come in three forms.
Participating preferred – they get their liquidation preference and share in the equity pro rata with the other investors.
Non-participating preferred – the get their liquidation preference but do not share in the equity pro rata with the other investors.
Participating preferred with a cap – the get their liquidation preference and share in the equity pro rata with the other investors up to a Cap.
Investors often use this to compensate for what they consider to be a high pre-money valuation.
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