What Is a 1x Liquidation Preference?

Investment agreements outline the financial relationship between founders and investors, defining how proceeds are distributed in various scenarios. Among these terms, liquidation preference is a fundamental concept that dictates the order and amount of returns to shareholders during specific company events.

What is a Liquidation Preference?

A liquidation preference is a contractual provision within an investment agreement that establishes the order of payment to shareholders during a “liquidation event.” Such events typically include the sale of the company, a merger, or its dissolution. This provision ensures that certain investors, often holding preferred stock, receive a predetermined amount from the proceeds before common shareholders. It functions as a protective mechanism for investors, providing downside protection for their investment. This allows preferred shareholders to recover their capital before common shareholders, including founders and employees, receive any proceeds.

The Meaning of 1x

The “1x” in a liquidation preference refers to a multiplier applied to the original investment amount. This means investors are entitled to receive their initial investment back one time before other shareholders receive proceeds from a liquidation event. For example, if an investor contributes $5 million with a 1x liquidation preference, they receive $5 million from sale proceeds before common shareholders are paid. This multiplier is a standard component of venture capital term sheets, establishing a clear priority in the distribution of funds. A 1x liquidation preference is common in early-stage deals, balancing investor protection and founder equity.

How 1x Liquidation Preference Works

A non-participating 1x liquidation preference means the investor has a choice: either receive their original investment back or convert their preferred shares into common stock and receive a pro-rata share of the proceeds. They cannot do both. This choice depends on which option provides a higher return based on the company’s sale price. If the company’s sale proceeds are limited, the investor typically chooses to receive their liquidation preference, ensuring capital recovery.

For example, an investor puts $2 million into a company, holding preferred shares with a 1x non-participating liquidation preference, and owns 20% of the common stock. If the company sells for $3 million, the investor takes their $2 million preference. The remaining $1 million goes to common shareholders. If they converted to common stock, their 20% share of $3 million would be $600,000, making the preference the better choice.

If the company sells for $20 million, the investor’s 1x liquidation preference is still $2 million. However, converting to common stock yields $4 million (20% of $20 million). In this successful exit, the investor converts shares to receive the $4 million, as it is greater than their $2 million preference. This non-participating preference acts as a floor, ensuring the investor gets at least their money back, but allows participation in significant upside.

1x Liquidation Preference and Participation

The distinction between non-participating and participating 1x liquidation preferences significantly impacts how proceeds are distributed during a company’s exit. With a non-participating 1x preference, investors must choose between receiving their original investment amount or converting their preferred shares to common stock to share in the remaining proceeds on a pro-rata basis. They do not receive both the preference amount and a share of the remaining funds. This structure requires investors to assess whether the company’s exit value makes conversion to common stock more financially advantageous than simply taking their preference.

In contrast, a participating 1x liquidation preference allows investors to “double-dip” in the proceeds. Investors first receive their 1x preference amount, and then they also participate pro-rata with common shareholders in the distribution of any remaining proceeds. This means they get their initial investment back and then a percentage of what is left over, effectively sharing in the upside alongside common shareholders. This type of preference is generally more favorable to investors and can result in reduced payouts for founders and common shareholders, especially in successful exits.

Participating preferences often include a “cap,” which limits the total amount an investor can receive from both their preference and participation. For example, a participating 1x liquidation preference might have a 2x or 3x cap on the total return. This means the investor receives their 1x preference and then participates until their total payout reaches the specified multiple of their original investment. Once the cap is reached, the investor no longer participates, and further proceeds are distributed solely among common shareholders.

Consider an investor who invested $1 million with a 1x participating liquidation preference and a 3x cap, owning 10% of the company. If the company sells for $15 million, the investor first receives their $1 million preference. The remaining $14 million is distributed pro-rata; the investor’s 10% share is $1.4 million. Their total payout is $2.4 million ($1 million + $1.4 million), which is below their $3 million cap.

If the company sells for $40 million, the investor first receives $1 million. They then participate in the remaining $39 million. Their 10% share would be $3.9 million, but their total payout is capped at $3 million. In this case, they receive $1 million from preference plus an additional $2 million from participation to reach the $3 million cap, leaving more for common shareholders.