It's common to hear the participating preferred stock (which has a liquidity preference and participation rights) referred to as a sneaky way to increase returns.  However, as we saw in my post, Preferred Stock:  How Liquidity Preference Impacts Investor Returns, liquidity preference has an smaller impact on returns as exit values increase.  While the liquidity preference does increase returns for investors, if that were the only objective there are better ways to achieve it.  Most obviously, returns on any given investment could be more effectively increased by negotiating lower pre-money valuations enabling investors to have a greater participation in the upside when big exits happen.  The potential additional payout from having more upside would very likely outweigh the downside protection that the liquidity preference provides.

This begs the question, how much downside protection does the liquidity preference provide investors?  In the downside scenario in my post, Preferred Stock:  How Liquidity Preference Impacts Investor Returns, the liquidity preference plays a key role, accounting for 50% of the returned capital.  However, not all companies have a $10M exit - many go to zero.  Without an exit event liquidity preference doesn't do much.

This leaves us asking ourselves, if liquidity preference has a relatively small impact on the upside and is not frequently leveraged on the downside, why is it used?

The main reason:  incentive alignment.  Liquidity preference ensures that the entrepreneurs are focused on realizing a big exit.  Early stage VCs invest in companies because they believe they can exit for several hundred million dollars or more.  Without the liquidity preference entrepreneurs may be tempted to pursue $10M exits - seeking a $5M personal payout before they realize the full potential of the company.  Liquidity preference enables investors to get their money back first in those situations, reducing the payout to the entrepreneurs keeping them enticed to seek the $100M exit.  Through liquidity preference the incentives are aligned; no one does well when the exits are small and everyone makes a lot of money when the exits are big.

This isn't to say that the impact of liquidity preference on returns in small exits isn't important - it can be for an individual investment.  However, the impact of liquidity preference on a VC's overall fund return probably isn't extremely significant.  In contrast, making sure that entrepreneurs are focused on making big companies always matters. My point here is that the main purpose of this structure is to align the incentives between investors and entrepreneurs, keeping everyone focused on making something really big.