Video: How Do VC Liquidation Preferences Actually Work?

For those who don’t know, a liquidation preference gives a venture capitalist the right to get their money back before other shareholders.

An example might be they might invest $5 million into a startup. That startup, when it gets sold, the VCs have a momentary decision where they can actually say I want my $5 million back, which means the investment effectively worked as a loan.

They just got their capital back. Or they can convert and participate in all the upside along with the other shareholders. The liquidation preference is a great risk mitigation tool for VCs. When the company doesn’t have a big exit but actually does generate some proceeds, it means the VCs get their money back, they haven’t lost their capital, and they can live to play another day.

Of course, if a company has a big exit, they convert and participate alongside everybody else. So it’s a way of mitigating their downside while also preserving their upside. Liquidation preferences are found in almost every single deal a VC will do.

Typically, they’ll ask for 1x, one time their money. Sometimes when it’s a real kind of tough situation or downside situation, they might ask for two or three times their money. That’s pretty rare. Typically, you’re going to see a 1x liquidation preference.

Remember, what that does is that means the VCs can get their money back if the company has kind of a modest exit. On a big exit, they’re always going to convert and play for the big upside.