Start-Up Corner: Venture Basics: Understanding Liquidation Preference

Jim Ryan wrote “Venture Basics: Understanding Liquidation Preference” in the Journal of Artificial Intelligence and Robotics. He explains one of the most important economic rights in venture capital financings and a core feature of preferred stock.

The article defines liquidation preference as the right of preferred stockholders to receive their invested capital, often multiplied by a negotiated factor, before common stockholders in a sale, merger, or liquidation. Jim distinguishes venture preferred stock from public-company preferred stock, emphasizing its convertible nature and role as downside protection rather than debt. Using clear examples, the article illustrates how different multiples can shift exit risk between investors and founders. It then outlines the principal types of liquidation preferences: non-participating, participating, and capped participating preferences, highlighting how each affects returns in both modest and successful exits. The discussion also addresses complexities arising from multiple series of preferred stock and evolving market conditions. Ryan concludes that understanding liquidation preferences is essential to translating business terms into enforceable legal rights and balancing investor protection with founder incentives. 

Read the full article.