Non-Participating Liquidation Preference Explained For Startup Founders

There are two major types of liquidation preference, and they are not the same.

The first is non-participating liquidation preference.

This is usually the more founder-friendly version because the investor must choose one path when the company is sold.

They can either:

Take their liquidation preference first, usually the agreed multiple of their original investment.

Or convert their shares to common shares and participate in the general distribution like other shareholders.

But they cannot do both.

For example, if an investor put in ₦100 million with a 1x non-participating liquidation preference, and the company is sold for ₦500 million, the investor will compare both options.

Option one: take the ₦100 million preference.

Option two: convert to common shares and take their ownership percentage of the full ₦500 million exit.

If the investor owns 25%, converting gives them ₦125 million.

So they will convert because ₦125 million is better than ₦100 million.

But if the company is sold for only ₦150 million, the same investor may choose to take their ₦100 million preference first, leaving the remaining ₦50 million to be shared among the common shareholders, including the founders.

The key point is this:

With non-participating preference, the investor picks one path.

They cannot take their preference and still participate again in the remaining proceeds.

That ceiling can protect founders.

Before you sign a term sheet, shareholders agreement, investment agreement, or preference share structure, make sure you understand whether the liquidation preference is participating or non-participating.

For startup legal advisory, term sheet review, shareholders agreement review, liquidation preference review, investor documentation, and founder protection, send me a mail through:

sahonlegal@gmail.com
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