What do we mean by liquidity preference? This is a key term for VC investors when negotiating their investment. Since it determines how the company or the pie will be divided in a liquidity event, the preference feature enables preferred stockholders to get their money back before anyone else. It gives them preference over common stockholders and it protects VC investors. On the downside, a liquidity event is any event where the shareholders receive proceeds for their equity in the company. Typical examples include a sale of the company, a merger, a change of control, bankruptcy, or a wind down.

An IPO is considered as another funding event for the company and not a liquidation event. There are two components that feature in a liquidation preference, and these are, one, the actual preference, and two, the participation feature. The actual preference pertains to the money returned to a particular series of the company's preferred stock ahead of other stockholders. Typical language in a term sheet would stipulate that a certain multiple of the original preferred investment per share is returned to the preferred investor before the common stockholders receive any consideration. The multiple is generally anywhere from one times to three times. In a down round or an investor friendly climate. A two times to three times liquidation Preference is not uncommon. The second component is whether the investor's shares are participating. There are three types of participating shares, full participation, capped participation, and non-participation.

A full participation feature of preferred stock enables VC investors to receive the liquidation proceeds on a pro-rata basis with common stock after the full payment of their liquidation preference has taken place first. This is sometimes referred to as a double dip because the preferred stockholder gets their original investment back through the preference feature and receives the pro rata share of the residual value of the company with common stockholders through participation. A capped participation feature of preferred stock is similar to full participation, but where the liquidation proceeds are capped after a certain return multiple, typically in the one to two times multiple range has been achieved.

If the participation multiple is three times, which means three times the original purchase price, it would mean that the preferred stock would stop participation on a per share basis once 300% of the original purchase price was returned, including any amounts paid out on the liquidation preference. This is not, not an additional three times return, rather an additional two times on top of the liquidation preference, assuming it were a one-time return.

A non-participation feature provides preferred stockholders with the option to convert to common stock and share pro rata in the liquidation proceeds or receive their liquidation proceeds as a preferred stockholder, this is the best option for founders because there is no double dipping allowed for preferred stockholders, but of course it is the least desirable option for VC investors.