To be clear for those who aren't following the salient detail here - the preferred stock does not convert to common if the liquidation preference is exercised.

To be clear for those who aren't following the salient detail here - the preferred stock does not convert to common if the liquidation preference is exercised. The investor gets up to their money back (1x preference), and no more. If they choose to participate pro-rated they convert to common first, and participate equally with everyone, without the preference. The investor would chose to convert to common when the sale price is greater than the post-money valuation of the deal. On this basis their pro-rated participation will be greater than the amount invested. If the sale price is less than the post-money valuation of the deal, they would be sensible to keep their preferred stock, and exercise their 1x preference, meaning they get their original amount back 100 cents on the dollar. The remaining is then split between the common shareholders proportionally (in effect without the dilution from the investor that exercised their preference). Mark Suster (@msuster) from GRP put together a good spreadsheet [1] that shows the preference effect on sale, including preferred non-participating stock and preferred-participating (PP) stock (essentially double dipping into sale proceeds). Brad Feld (@bfeld) from Foundry Group has a good write up of the different types of participation on his blog [2]. [1]: http://www.docstoc.com/docs/47831420/Venture-Capital-Valuation-Spreadsheet http://www.docstoc.com/docs/47831420/Venture-Capital-Valuati... [2]: http://www.feld.com/wp/archives/2005/01/term-sheet-liquidation-preference.html http://www.feld.com/wp/archives/2005/01/term-sheet-liquidati...