Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Structured Liquidation Preferences in Acquisitions
Transcript
- Lucas: So, Palantir shares are up fourteen and a half percent in the last five days. That's not just noise — it comes on the back of a big government contract renewal and chatter about their Foundry platform spinning off into a separate entity. Luna: Right, I saw that. And it's interesting because Palantir has never been a typical startup — they've been public since 2020 via a direct listing. But the spin-off talk raises a question we haven't covered on this show: how founders can use structured liquidation preferences to protect their payout in an acquisition. Lucas: Exactly. Liquidation preferences are usually discussed in the context of venture capital term sheets — you know, the 1x non-participating preferred that VCs get. But founders can also negotiate preferences for themselves when they sell the company. It's a way to say, 'I want to get my money out first, before common shareholders.' Luna: So it's like a priority lane in a traffic jam. If the company sells for a certain price, the founder gets a guaranteed return before anyone else? Lucas: Exactly. And it can be structured in layers. Let's say you have a B2B SaaS company doing fifty million in revenue. You get an offer for four hundred million. The founding team holds ten million shares of common stock. But they've also negotiated a two-times participating liquidation preference on their shares. Lucas: That means before any common shareholder — including employees with options — gets a dime, the founders receive two times their original investment, plus they participate pro rata in the remaining proceeds. In this scenario, if the founders originally invested ten million, they get twenty million off the top, then their share of the remaining three hundred eighty million. Luna: That sounds aggressive. Does that actually fly in real acquisitions? I imagine acquirers push back hard. Lucas: It depends on the leverage. If the company has multiple bidders or a strong strategic fit, founders can push for it. According to data from the 2024 Venture Exit Survey by Fenwick, twenty-three percent of all venture-backed exits included some form of liquidation preference beyond the standard one-times non-participating. That's up from eighteen percent in 2020. Luna: So it's becoming more common. And I can see why — founders want to de-risk the exit, especially if they've taken little salary for years and have most of their net worth tied up in the company. Lucas: Right. And the structure can be tailored. Some founders use a 'capped participation' — they get, say, two times their preference and then participate until they've received three times total. Others use a 'non-participating' preference, where they choose between taking the preference or converting to common and sharing the pool. Luna: Which one do you see more often in practice? Lucas: For founders, non-participating is actually more common, because it's cleaner. The founder can elect to take their one-times or two-times preference, or convert to common and get a piece of the full distribution. The decision flips on the exit size. If the exit is huge — say, a billion dollars — converting to common almost always pays more. If it's a smaller exit, taking the preference guarantees a floor. Luna: That makes sense. So it's really about downside protection without capping the upside. Lucas: Exactly. And there's a tax angle too. If the preference is structured as a 'redemption right' rather than a liquidation preference, it might be treated as a sale of stock rather than a dividend, which can change the tax treatment from ordinary income to capital gains. That's territory where you really need a good tax attorney. Luna: I want to circle back to that spin-off idea with Palantir. If Foundry becomes a separate company, the founders of that entity — who are probably current Palantir executives — could negotiate preferences in the spin-off's charter. That would protect them if the new entity gets acquired later. Lucas: That's a smart point. In a spin-off, the new company's board sets the capital structure. Founders can put preferences in place from day one. It's not common, but it happens. And it's a way to signal to future acquirers that the management team expects a premium for their technology. Luna: It's also a negotiating chip. If a potential acquirer knows the founders have a two-times preference, they might offer a higher price to avoid triggering a messy preference stack. Lucas: Right. But there's a flip side: some acquirers walk away if the preference structure is too aggressive. They don't want to overpay for a company where the founders get a guaranteed return regardless of performance. So it's a balancing act. Luna: What about the interaction with earnouts? Can you have both a liquidation preference and an earnout in the same deal? Lucas: You can, but it gets complicated. The earnout is usually paid out of future revenue, so it's subordinate to the preference in the current deal. But if the earnout is guaranteed or escrowed, it can effectively function as additional preference. We've seen deals where the earnout is structured as a 'preferred earnout' — meaning it's paid before common shareholders get any of the earnout pool. Luna: So it creates a hierarchy within the earnout itself. That's pretty sophisticated. Lucas: It is. And it's becoming more common as founders get more educated about exit mechanics. Ten years ago, most founders just signed whatever term sheet the buyer put in front of them. Now, they're hiring lawyers who specialize in exit negotiations and benchmarking preferences. Luna: I want to ask about the data you mentioned earlier — the twenty-three percent of exits with enhanced preferences. Does that include both VC and founder preferences? Lucas: It includes all preferences beyond the standard one-times non-participating. So it covers both. But the Fenwick survey breaks it down: about fourteen percent were vc only preferences, and nine percent were founder or management preferences. So founders are definitely using them, but not as aggressively as VCs. Luna: That makes sense. VCs have more leverage because they control the board seats and future funding. Lucas: Exactly. But founders can gain leverage by having multiple acquirers interested. In a competitive process, the buyer is less likely to balk at a preference structure. And some buyers actually prefer it because it aligns incentives — the founder gets a guaranteed floor, so they're less likely to sabotage the deal. Luna: Right. And speaking of alignment, this is exactly the kind of deep-dive conversation we love bringing you on this show. We don't run ads — it's just us talking through the mechanics that matter for founders and operators. Lucas: Yeah, and if you find these episodes useful for what you're building or running, the best way to support that is at buy me a coffee dot com slash fexingo. It keeps us ad-free and focused on the details. Luna: And we really appreciate the listeners who've already done that. It lets us tackle these niche topics without worrying about sponsors. Lucas: Absolutely. So back to preferences — one thing I want to emphasize is that the specific language matters. For example, a 'participating' preference that is 'senior' to all other shares means the founder gets paid before anyone, even before the VCs. But if it's 'pari passu' — that's Latin for 'on equal footing' — the founder and VCs share the preference pool proportionally. Luna: And that distinction can mean millions of dollars in a large exit. So founders need to read the term sheet carefully, not just the headline number. Lucas: Exactly. And also note that preferences can be 'stacked' — meaning there are multiple layers. For instance, Series A investors have a one-times preference, Series B investors have a two-times preference, and founders have a one-times preference. The order of priority in liquidation is determined by the charter. Usually, later rounds are senior to earlier rounds, but not always. Luna: It's like a capital stack in real estate. The more layers, the more complex the waterfall. Lucas: Right. And if the exit price is just above the total preference amount, the common shareholders — including employees — might get zero. That's called a 'liquidation overhang.' It's a big reason why some acquisitions fail to retain talent. Luna: So founders who negotiate a large personal preference might be hurting their own employees. That's a tough ethical line. Lucas: It is. And some founders address it by setting aside a pool of common shares for employees that are excluded from the preference stack. Or they negotiate a 'carve-out' where a certain amount of proceeds go to employees before the preferences kick in. It's a way to balance founder protection with team morale. Luna: That seems like a smart middle ground. You get your floor, but the team still gets something. Lucas: Exactly. And as we head into the second half of 2026, with the IPO market still lukewarm — we've seen only about sixty IPOs this year, down from a hundred and ten last year — we're likely to see more creative acquisition structures. Preferences will be a big part of that. Luna: So the takeaway for founders is: don't just focus on the valuation. Think about the preferences, the order, and the carve-outs. Those details determine what you actually walk away with. Lucas: And bring in a lawyer who does this every day. The cost of a good exit lawyer is a fraction of what you could lose by signing a bad term sheet.