What Tech Employees Need to Know About VC Liquidation Pref (So You Don't Get Screwed)
If you work at a venture-backed startup, there's a term that will almost never come up in the company All Hands, but could significantly impact your financial outcome in a liquidity event: liquidation preference.
Whether you're holding RSUs, common stock, or options, it’s essential to understand how venture capitalists get paid in an acquisition or IPO — and how that may affect what, if anything, you receive. This isn’t about "doom and gloom"; it's about being informed so you're not caught off guard or over-estimate your payout.
What Is a Liquidation Preference?
Liquidation preference is a contractual right that gives investors (typically preferred shareholders like VCs) their money back before common shareholders (you) get anything in a liquidity event — like an acquisition or IPO.
In plain English: VCs get paid first.
If a company is sold, the liquidation preference determines how the proceeds are distributed. The most common structure is a 1x preference, meaning the VC gets 100% of their original investment back before any other payouts are made.
But that's just the starting point. Preferences can be:
Non-participating. (VCs get their money back, or convert to common and share in the upside — not both) -> which is the most common
Participating. (VCs get their money back and also share in the upside, sometimes with a cap) -> which is less common, but still definitely exists
Let’s unpack what that looks like with real-world examples.
Why VC Preference Matters to You
As a tech employee, you're likely holding common stock or options that convert into common. That puts you last in line.
And with high VC fundraising in the last 5+ years (many companies raised at inflated valuations in 2020–2021), many startups are now worth less on paper than the amount invested.
In that scenario there's a real chance that (1) The VCs get paid, but (2) You don't!
Even if the headline sounds like a "$200M exit"… you could still walk away with nothing if preference overhang is in play.
Example 1: When Liquidation Preference Doesn’t Hurt You
VC invested: $50M (with 1x non-participating preference) at a $200m valuation, owning 25%
Company valuation at exit: $500M
Example Employee: Owns 0.25% of diluted common shares
VC outcomes: (1) Money back ($50m) or share of upside ($125m; 25% * $500m)
In this case, the share of the upside gives the VCs higher dollars, so they select to convert to common shares (same as you the employee). Example employee shares fully in the upside ($500m * 0.25% = $1.25m)
Bottom line: Liquidation preference exists, but doesn't block your participation because the exit was large relative to the VC investment.
Example 2: When Liquidation Preference Does Hurt You
VC invested: $50M (with 1x non-participating preference) at a $200m valuation, owning 25%
Company valuation at exit: $105M
Example Employee: Owns 0.25% of diluted common shares
VC outcomes: (1) Money back ($50m) or share of upside ($26.25m; 25% * $105m)
The Liquidation Preference gives the VCs more dollars ($50m vs. $25m), so they select that. The remaining $55 million is distributed to common; example employee gets $55 * 0.25% = $137k
Outcome: Majority of proceeds go to the VC. You (and your options or RSUs) get something, but less than you expected.
This is common when a company does poorly after a larger VC raise round.
Example 3: When Liquidation Preference Takes It All
VC invested: $50M (with 1x non-participating preference) at a $200m valuation, owning 25%
Company valuation at exit: $40M
Example Employee: Owns 0.25% of diluted common shares
VC outcomes: (1) Money back ($40m, since no more is available) or share of upside ($10m; 25% * $40m)
There are not enough funds to even fully cover the VC Liquidation Preference ($40m vs $50m), so they take 100% of the proceeds. No funds remain for common shareholders, and the example employee gets nothing
Outcome: All of the proceeds go to the VC. You (and your options or RSUs) get $0
As noted before, this is common when a company does poorly after a larger VC raise round.
Participating Preference: The Extra Twist
The above examples give you enough to understand how VC preference can materially impact payout to employees in a liquidity event. We will take that a step further here with two additional elements:
(1) Participating Liquidation Preference. This is less common, but still definitely exists in the VC world. If the liquidation preference is participating, it will reduce the payout (if any) to an employee -- because VCs get their money back and also share in the upside (sometimes with a cap). Let's replay example 2 above, but make it participating:
VC invested: $50M (with 1x participating preference up to a 2x cap) at a $200m valuation, owning 25%
Company valuation at exit: $105M
Example Employee: Owns 0.25% of diluted common shares
VC outcome: (1) Gets money invested back ($50m) + shares in the upside for the remainder up to a 2x cap ($55m * 25% = $13.75m) = $63.75m total
The Example Employee would still get something, but instead of $137.5k, it would be closer to $103k
Stacked Preferences & > 1.0 preference
The complexities of preference can grow beyond the above as well.
Preference Stacks with each round. Most VC-backed companies raise multiple rounds. Each round creates a new VC-pref calculation, which stack on top of one another.
Higher Preference rate. Rather than a VC having a 1.0x preference, it could be a higher number (e.g. 1.5x).
If you'd like to dive deeper into these topics, I recommend reading this article on Angel List
What You Can Do
You don't need to panic. But you do need to be informed:
Ask your company (or read your option paperwork) to understand where your shares sit in the capital stack.
Understand how much has been raised, on what terms, and what liquidation preferences exist.
Model potential outcomes — especially if you're negotiating a job offer or deciding whether to exercise your options. Visit our Key Questions To Ask Page for more details
Work with a financial advisor who understands equity comp and liquidity dynamics in venture-backed companies.
Final Thought
Liquidation preference isn’t inherently bad. It’s part of the deal that allows startups to raise capital.
But when you're an employee with meaningful equity, knowing how the waterfall works can save you from heartbreak—or at least make sure you're planning with eyes wide open.
We’ve helped hundreds of tech professionals model liquidity scenarios and plan around these complexities. If you're unsure how your equity might play out in an exit, reach out or explore our Equity Comp Academy for more resources.
Article Last Updated: May 27, 2025