What is a liquidation preference in an exit?

A liquidation preference is a clause in the investment contracts that decides who gets paid first, and how much, when a company is sold. The order in which the sale price is paid out to shareholders is called the waterfall. In a standard structure, the most recent investor sits at the top of the waterfall. Founders and employees with common shares, the ordinary shares without special rights, sit at the bottom.

The cap table, the list of who owns which shares on which terms, carries all of these clauses. Peter Möllmann is a tech M&A (mergers and acquisitions) lawyer and partner at PXR, a tech M&A law firm in DACH (Germany, Austria and Switzerland). As my CEO Briefing on cap tables at exit describes, he often sees a cap table nearly kill a deal that has a real buyer and the right price. In almost every case, the damage was done years before the exit began.

How can liquidation preferences split shareholders in an exit?

They give investors different results at the same sale price, so investors can want different things. Consider this scenario from my CEO Briefing:

• Your last investor came in at a high valuation with a 2x liquidation preference.
• An earlier investor came in much lower and sits on a 50x return at the current offer price.

The earlier investor wants to sell now. The last investor wants to wait for a higher price, because a 2x preference on a late-stage entry still means it barely made money.

Thirty shareholders can mean thirty different incentive structures, all in one exit process.

Which liquidation preference clause can break a sale?

A preference that only applies to a 100% sale. Peter sees this failure repeatedly. In the cases he describes, the founders never questioned the clause at signing. At that point, a sale of less than 100% seems far away.

Then a buyer wants 80%. The clause no longer applies, and the whole waterfall breaks down. The founders also cannot use their drag-along rights, the rights that let a majority of shareholders require the others to sell on the same terms. Now everything has to be fixed under deal pressure, which is the worst possible time.

In Peter's words, such contracts were drafted by people who had never done an exit. Once you are in the process, they cannot be repaired.

What happens to employee stock options at exit?

Employees with stock options can find out late that their shares are worth less than they expected, or nothing at all. It depends on how the waterfall plays out at the actual sale price.

This creates friction inside the company exactly when the team needs to be aligned and performing. Some founders discover the problem for the first time a few weeks before closing. Modeling the waterfall early shows what the employee stock option plan (ESOP) is worth at different sale prices before the team learns it during the deal.

Why check the waterfall before you react to an offer?

Because the headline price does not tell you who gets what. An offer that looks attractive for the company can look very different for founders and employees once every preference is paid.

An attractive number can also come for the wrong reasons. In my CEO Briefing on the Fishing Expedition, Peter explains that an indicative offer, a first non-binding price signal, is easy to write and costs nothing. Some buyers, often direct competitors, use one mainly to get access to your financials, roadmaps and customer data. An offer on the table feels like validation, and that feeling makes founders open doors that should stay closed.

Two checks protect you before you open up:

1. Model the waterfall at the offered price: know what each shareholder group receives before you negotiate.
2. Test the buyer: ask for reciprocal disclosure early. A serious buyer shares information about itself and brings external advisors. If the transparency stays one-sided, be willing to stop the process, even with an offer on the table.

When should founders fix their cap table for an exit?

Early, ideally before the next funding round and long before a term sheet with a buyer. The fix is not complicated, but it only works before the exit process starts. Peter recommends three steps:

1. Choose the right drafter: have your financing contracts drafted by someone who has actually closed exits as well as financing rounds.
2. Define the deal team majority: set in your shareholder agreement which majority decides who sits on the deal team when the time comes.
3. Model the cap table at different exit prices and structures: look past the headline number to who gets what in each scenario, including a sale of less than 100%.

A cap table is written for a financing event. An exit is a different transaction, and the contracts need to work for both.