Brian Nichols is the co-founder of Angel Squad, a community where you’ll learn how to angel invest and get a chance to invest as little as $1k into Hustle Fund's top performing early-stage startups.

The Exit Everyone Forgets to Plan For

Most founders think about the big exit. The acquisition that makes everyone rich. The IPO that validates years of grinding.

But here's what nobody talks about: most exits aren't home runs. They're singles or doubles. Sometimes you sell for $30 million instead of $300 million. And that's when liquidation preference stops being theoretical and starts being your entire reality.

I've watched companies sell for what sounds like a lot of money, only for the founders to walk away with almost nothing. Meanwhile, investors got their money back (or more). How does that happen?

Liquidation preference.

This is the clause in your term sheet that determines who gets paid what when the company exits or shuts down. And if you don't understand it cold, you're setting yourself up for a surprise that could cost you everything.

What Liquidation Preference Actually Means

When investors put money into your company, they typically buy preferred stock. You and your employees hold common stock.

That "preferred" designation isn't just a fancy name. It comes with actual preferences, and the biggest one is liquidation preference.

In simple terms: investors with liquidation preference get paid before common shareholders when there's an exit.

Standard liquidation preference is 1x. If someone invested $2 million, they get their $2 million back before anyone else sees a dime. After that? Everyone participates according to their ownership percentage.

This is completely reasonable. Investors took a risk. They should at least get their money back before common shareholders profit.

But here's where it gets complicated: not all liquidation preferences are created equal. And as you raise multiple rounds, these preferences can stack in ways that seriously mess up your cap table math.

Participating vs Non-Participating Preference

There are two main flavors of liquidation preference, and the difference is huge.

Non-Participating Preference (Standard and Fair) With non-participating preference, investors choose between:

1. Taking their liquidation preference (getting their money back), OR
2. Converting to common and participating in the proceeds based on ownership

They pick whichever gives them more money.

Example: An investor put in $5 million at a $20 million post-money valuation (25% ownership). The company sells for $30 million.

Option 1: Take the $5 million preference Option 2: Convert to common and take 25% of $30M = $7.5 million

They'll take option 2. Everyone wins.

Participating Preference (Rare but Brutal) With participating preference (sometimes called "double-dipping"), investors get their liquidation preference back AND THEN participate in the remaining proceeds based on their ownership.

Same example, but with participating preference:

They get their $5 million preference first. That leaves $25 million. They own 25%, so they get another $6.25 million from the remaining pool. Total: $11.25 million out of a $30 million exit.

The founders and employees split what's left after all investors are paid. In a participating preference scenario with multiple rounds, that can be way less than you'd expect.

How Multiple Rounds Create a Preference Stack

Here's where things get really messy: as you raise more rounds, liquidation preferences stack up.

Let's walk through a realistic example:

Seed Round: Raise $2M at $8M post-money. Investors have 1x liquidation preference on $2M.

Series A: Raise $8M at $32M post-money. Investors have 1x liquidation preference on $8M.

Series B: Raise $20M at $80M post-money. Investors have 1x liquidation preference on $20M.

You've now raised $30 million total. Your preference stack is $30 million.

If you exit for $40 million:

• All investors get their $30M back first
• Only $10M remains for everyone else (including founders and employees)

Even though you built a company that sold for $40 million, you might personally walk away with just a few hundred thousand dollars. Meanwhile, investors got a solid return.

Is this fair? Honestly, yes. Investors put in $30 million of risk capital. Getting it back before common shareholders profit makes sense.

But it's something most founders don't think about when they're signing term sheets.

The Down Round Problem

Things get way worse in down rounds.

A down round is when you raise money at a lower valuation than your previous round. This usually happens when things aren't going well.

Let's say after that Series B at $80M post, growth stalls. You need more capital, but now you can only raise at a $50M valuation.

The new investors coming in want protection. They might negotiate for:

• Higher liquidation preference (2x or 3x instead of 1x)
• Senior liquidation preference (they get paid before earlier investors)
• Participating preference

These terms exist to protect investors in risky situations. But they can completely flip your cap table dynamics.

In some down round scenarios, the preference stack gets so high that common shareholders (founders and employees) need a massive exit just to see any money at all.

Red Flags in Term Sheets

When you're reviewing term sheets, here's what to watch for:

Anything above 1x non-participating preference is a red flag. Unless you're in a really tough situation (down round, running out of cash, no other options), you shouldn't accept this.

Participating preference is a huge red flag. Some investors will try to sneak this in. Push back hard. It's not standard and it's not fair.

Senior liquidation preference for new investors. This means they get paid before earlier investors. It screws your existing cap table and signals that something's wrong.

Cumulative dividends. Some terms include dividends that accumulate if not paid. This effectively increases the liquidation preference over time. Avoid if possible.

The best term sheets have clean, simple liquidation preference: 1x non-participating across all rounds.

How to Protect Yourself

If you're a founder raising money:

Negotiate hard on preference terms. This is one area where you should push back. 1x non-participating is standard. Anything else needs serious justification.

Model out exit scenarios. Before signing any term sheet, model what happens at different exit prices. What if you sell for $20M? $50M? $100M? How much do founders get in each scenario?

Consider your existing preference stack. Each new round adds to this. If you're already at $30M in preferences, raising another $20M at rough terms could make exits very difficult.

Watch for cumulative terms. Make sure you understand everything that affects the preference amount over time.

If you're an investor:

Keep terms simple and fair. Your job is to help build big companies, not extract maximum value from small exits.

Think about alignment. If founders can't make meaningful money below a certain exit size, what behavior does that create?

Be transparent about preference stack implications. Help founders understand what terms mean for their outcomes.

The Practical Reality

In the real world, liquidation preference discussions happen during term sheet negotiations. Most founders don't negotiate this term much because:

1. It feels awkward to argue about exit scenarios before you've even started working together
2. Many founders don't fully understand the implications
3. Standard 1x non-participating feels reasonable (and it is)

But you should still pay attention. Read the terms carefully. Model the scenarios. Ask questions.

And if someone offers you anything other than 1x non-participating, slow down and understand why. There might be legitimate reasons (you're in a tough spot, it's a down round, investors need extra protection). But make sure you're making that tradeoff consciously, not by accident.

Getting Smart About Terms

When you're evaluating deals as an investor, you need to understand how preference terms affect your returns. When you're raising as a founder, you need to understand how they affect your outcomes.

The best relationships happen when everyone knows what they're signing up for. No surprises. No misaligned incentives. Just clear terms that make sense for building valuable companies.

Because at the end of the day, liquidation preference is insurance for investors. It protects downside while still allowing upside through ownership. Used correctly, it's a fair and reasonable term.

Used incorrectly, it can destroy companies and relationships.

Know the difference. Ask the questions. Model the scenarios. And build companies big enough that liquidation preference becomes academic because everyone's making real money.

That's the goal anyway.

Join Angel Squad to connect with investors who understand these nuances and founders who've navigated term sheet negotiations successfully. 

Learn from people who've been on both sides of the table and can help you make smarter decisions about terms, valuations, and building valuable companies.