Liquidation Preference: A Simple Guide for First-Time Indian Founders

Editorial
Nov 19, 2025
4 min read

This article was written by Anjali Nair, Associate, and Karthik Jayakumar, Partner.

When you are raising funds for your startup in India, you will likely hear the term "liquidation preference". This article will explain what liquidation preferences are, and why it matters to a first-time Indian founder.

What is Liquidation Preference?

Think of liquidation preference as a safety net for investors. It determines who gets paid first and how much, when there's a liquidation event, also commonly referred to as a liquidation event or exit event. Essentially, it is the investor's way of saying, "I want my money back before others get theirs."

What is a liquidation event?

A liquidation event is when there is money which needs to be distributed to the shareholders or founders of the company. Such as, when your company is acquired for cash, the sale proceeds will need to be distributed between the shareholders or founders.

Similarly, there are multiple other instances when money will have to be distributed between founders and shareholders of the company such as a merger, sale of assets, sale of majority stake of the company or winding up.

These events are commonly also referred to as an Exit Event. These are usually set out very clearly in the shareholders agreement which are executed between the company, founders and shareholders.

A common misconception is that a liquidation preference only kicks in when your company winds up. In reality, it applies to any exit scenario whether that's selling your company, merging with another business, or even a successful acquisition. Anytime an event occurs that causes ownership to be cashed out or value to be distributed, a liquidation preference matters. The moment when the money is actually distributed to investors or shareholders is commonly referred to as a payout.

Participating Preference vs. Non-Participating Liquidation Preference

This is one of the most important aspects of Liquidation Preference that you have to bear in mind, because it decides how much investors actually take home when a payout happens:

Non-Participating Preference: Here the investor gets to choose one of the two options (a) take back their original investment amount (for instance 1x or 2x) OR (b) take their share of the of the total payout based on how much of the company they own, whichever is higher. The investors will pick whichever gives them more money, but not both, and nothing beyond that. This is generally more founder-friendly because investors don’t get paid twice.

Participating Preference: This is also referred to as the “double-dip” model, wherein the investor first gets their investment amount back (and) whatever assured return is allocated to them (and) then also share in whatever remains of the proceeds - just like the other shareholders and founders, in proportion to their shareholding. This can significantly reduce what is left for founders, and in some deals include a cap. For example, investors can receive up to 2x their investment in total, after which they stop participating.

Capped vs Uncapped Liquidation Preference

The following aspects of liquidation preference is important for a founder to keep in mind, while reviewing the investment documents:

Capped Liquidation Preference: This ensures that there is a limit to how much an investor can receive often expressed as a multiple of their original investment.
Uncapped Liquidation Preference: This allows investors to keep participating with no upper limit, which can eat into the founders’ share significantly.

Most founder-friendly deals have a cap to make sure investors do not take too much of the upside in a big exit.

Why does liquidation preference matter to Indian founders?

While a liquidation preference does not affect day-day operations of a company, it can hugely determine, who gets what at the time of an exit. A deal with a 1x non-participating liquidation preference might leave a founder with a healthy payout. However, a deal with 2x participating preference across multiple rounds may mean the investors effectively get everything.

Set below are illustrations for better understanding of the same:

Let’s say your company is sold for INR 30 crore.

Investor’s investment: INR 10 crore
Founder ownership: 60%
Investor ownership: 40%

Now, let’s see what happens under two common scenarios:

1× Non-Participating Preference

The investor can choose between:

a) getting their investment back (INR 10 crore),

b) taking 40% of the total sale proceeds (40% of INR 30 crore = INR 12 crore).

The investor will choose INR 12 crore, and the founders share the remaining INR 18 crore.

2 x Participating Preference

Here the investor first gets 2x their investment amount (INR 20 crores), and then also joins the founders to split what is left (INR 10 crores) in proportion to their ownership (i.e., 40:60)

a) 20 crore (preference) + INR 4 crore (40% of remaining INR 10 crore) = INR 24 crore total

AND

b) Founders get the balance INR 6 crores

Even though the company sold for INR 30 crore, founders only get INR 6 crore, while the investors take most of the payout.

This indicates why understanding the concept of liquidation preference for a founder is so important, because the real difference between 1 x non-participating and 2 x participating can completely change the founder’s exit outcome.

Multiple Share Classes

As the business grows and raises more funds from various investors, each investor may hold different types of securities, each with its own priority.

(i) Debt holders (if any) get paid first (this is by design under law, and cannot be tampered with).

(ii) Preferred shareholders (usually, investors) come next.

(iii) Equity shareholders (usually the founders and employees) get what is left.

Among the preferred shareholders, later-round investors sometimes negotiate a higher priority over earlier investors. In other deals, everyone shares equally within the same class (pari passu).