Explaination: Liquidity Preference term is a necessary term in any term-sheet since it stipulates the payout order at the instance of liquidation of the Start-up
How it applies to Startup/Investor and its impact: Liquidity Preference term is important for the Investors as it provides them with the knowledge as how they will be paid in case any liquidity event occurs. Generally, first right over the proceeds arising because of Liquidity event goes to the New Investors, followed by Existing Investors and if still anything is remaining the same goes to the Founders.
Liquidation Preference is of two types i.e. Participatory and Non-Participatory. In Participatory, the Investors get the amount of their investment (including any accrued and unpaid dividends) plus proposed the value to be derived in the Liquidation proportionate to the Investor’s fully diluted shareholding in the Company.
In Non-participatory, the Investors are only entitled to either the Investment Amount (including any accrued or unpaid dividends) or proposed the value to be derived in the Liquidation proportionate to the Investor’s fully diluted shareholding in the Company; whichever is higher.
Participatory Liquidation Preference is a double dip and therefore is a loss for the other investors. This is the reason why Investors generally negotiate for Non-Participatory Liquidation Preference as it allows the other investors with an opportunity to participate in the liquidation proceeds.
Detailed of types of Liquidation Preference Available here – http://bretthard.in/post/examples-of-liquidation-preferences