When a Startup Is Sold, Who Gets Paid First?

For many startup founders, the number that ultimately determines how much money they and their investors “take home” is not the company’s valuation at the time of financing. Instead, it is the liquidation preference structure that applies at exit.

Under the model documents published by the National Venture Capital Association (NVCA), Article 2 of the Certificate of Incorporation sets out in detail how proceeds are distributed when a company undergoes a liquidation, sale, or merger. Although the drafting appears technical, the core question is straightforward: When the company is sold, who gets paid first, how much do they receive, and how is the remainder divided?

If you are currently navigating fundraising negotiations or M&A transactions—or would like to proactively assess how liquidation preferences and escrow structures may impact your founding team’s actual returns, please contact Roy Wang, Esq. at roy.wang@consultils.com, to discuss your specific needs.

Liquidation Preference: The Core Exit Mechanism

In a typical venture capital structure, investors hold preferred stock, while founders and management hold common stock. The most common structure is the 1x non-participating preferred stock.

Under this structure, investors have a “two-option” right at exit:

1. Return of capital – The investor may choose to receive back an amount equal to the original investment (a 1x return). Any remaining proceeds then go to common shareholders.

2. Conversion option – If the company is sold at a high price, the investor may convert preferred shares into common shares and participate pro rata in the total distribution.

In simple terms, the investor can either reclaim the invested principal first or convert and share in upside gains.

When the sale price is modest and the investor elects to take the 1x preference, the allocation is conceptually clean: the investor receives the invested amount, and the remainder goes to common stockholders.

However, real-world transactions are rarely this simple.

The Complication: Escrow and Deferred Consideration

In most acquisitions, buyers do not pay the full purchase price at closing. Instead, part of the purchase price is often held back through:

• Escrow arrangements to cover potential post-closing liabilities

• Earn-outs tied to future performance

• Other contingent payments

For example, a buyer may deposit a portion of the purchase price into a third-party escrow account to cover undisclosed liabilities discovered within a year.

This creates a critical legal and economic question:

If part of the purchase price is uncertain or deferred, how should it be treated for purposes of liquidation preference calculations?

Section 2.3.4 of the NVCA model Certificate of Incorporation addresses precisely this issue.

A Practical Example

Assume:

• An investor invested $1 million

• The investor holds a 1x liquidation preference

• The company is sold for $1.5 million

However, the payment structure is:

• $1.35 million paid at closing

• $150,000 placed in escrow, to be released one year later

One year later, the escrow is fully forfeited due to post-closing claims. The company ultimately receives only $1.35 million.

If we ignore escrow mechanics and simply look at the actual proceeds:

• Investor receives $1 million (1x preference)

• Common shareholders receive $350,000

That is the baseline liquidation preference logic. But how escrow is legally characterized makes a significant difference.

Two Approaches to Escrow Treatment

1. Initial Consideration Approach

Under this approach, the full stated purchase price ($1.5 million) is treated as the transaction value for allocation purposes.

Distribution would theoretically be:

• Investor: $1 million

• Common shareholders: $500,000

Because the escrow is considered part of the total consideration, any loss from escrow forfeiture is shared proportionally among all shareholders.

If the $150,000 escrow is entirely lost:

• Investor effectively receives approximately $900,000

• Common shareholders receive approximately $450,000

Here, the investor shares in the escrow risk.

2. Additional Consideration Approach

Under this approach, only the cash actually received at closing ($1.35 million) is considered in determining liquidation preference payouts.

Distribution would be:

• Investor receives full $1 million preference

• Common shareholders receive $350,000

If the $150,000 escrow is later forfeited, the loss falls entirely on the portion that would have gone to common shareholders.

In this scenario:

• Investor receives full $1 million

• Common shareholders absorb the escrow loss

Here, the liquidation preference is fully protected.

Economic Comparison

Treatment Method	Preferred Stock Receives	Common Stock Receives
Initial Consideration	$900,000	$450,000
Additional Consideration	$1,000,000	$350,000

The economic consequences are clear:

• Under the Initial Consideration approach, investors share in escrow risk.

• Under the Additional Consideration approach, investors are fully protected and common shareholders bear the uncertainty.

Why This Matters in Negotiations

Founders typically prefer the Initial Consideration approach because it spreads escrow risk across all shareholders. In lower-priced exits, this may prevent escrow losses from wiping out common shareholder proceeds entirely.

Investors, on the other hand, generally insist on the Additional Consideration approach. From their perspective, liquidation preference represents a minimum return floor. Escrow risk, they argue, reflects operational exposure and should not dilute their principal protection.

The Bigger Picture: Risk Allocation, Not Just Drafting

At its core, liquidation preference determines who gets paid first. The escrow treatment provisions determine who bears the uncertainty when part of the purchase price is contingent or at risk.

Although this may appear to be a technical drafting issue, it is fundamentally a negotiation over risk allocation between founders and investors. Understanding these mechanics early—at the financing stage—helps founders evaluate term sheet structures more clearly. It also prepares companies for future M&A negotiations, where escrow and contingent consideration are almost always present.

In the end, exit outcomes are not determined solely by valuation headlines. They are shaped by the legal architecture beneath them.

If you are currently navigating fundraising negotiations or M&A transactions—or would like to proactively assess how liquidation preferences and escrow structures may impact your founding team’s actual returns, please contact Roy Wang, Esq. at roy.wang@consultils.com, to discuss your specific needs.

Disclaimer: The materials provided on this website are for general informational purposes only and do not, and are not intended to, constitute legal advice. You should not act or refrain from acting based on any information provided here. Please consult with your own legal counsel regarding your specific situation and legal questions.

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As Partner and Head of M&A at ILS, David advises technology companies on venture financings, M&A, and cross-border transactions—bringing top-tier legal expertise and deep technical insight. He has closed $3B+ across 100+ deals, supporting clients from early-stage startups to global enterprises across the full corporate lifecycle, with a dealmaking style that combines strategic judgment and crisp execution.

Previously, David was Head of Legal at Humane, Inc., an AI unicorn acquired by HP, and practiced at Wilson Sonsini, Latham & Watkins, Cooley, and Gibson Dunn. He is known as both legal counsel and strategic business partner on complex, high-stakes transactions across AI, clean energy, biotech, and software.

Email: david.liu@consultils.com | Phone: 626-344-8949

Roy specializes in corporate, compliance, regulatory, and financing matters, with extensive experience in executing complex transactions and navigating sophisticated regulatory frameworks to support business strategy.

He began his career at a Magic Circle firm and has over five years of experience across derivatives and structured finance, financial regulation, and international commercial arbitration, advising clients on cross-border financing and regulatory compliance.

With a strong global practice background, Roy provides strategic, practical guidance on complex legal matters with both local and international implications.

Email: roy.wang@consultils.com | Phone: 626-344-8949