Liquidation preferences are designed to protect investors in case a deal goes sour, and can give some extra upside if the deal turns out to be good but not great. If the company goes under or gets sold (a "deemed liquidation event"), the liquidation preference means that the investors get a certain amount of money before founders get paid.

The liquidation preference is the amount that the preferred stockholders will get paid back on a "deemed liquidation event," before any money goes to the founders. It is usually expressed as a multiple of the price per share paid by investors in the financing. So, a one-times (or "1x") liquidation preference would mean that investors would get back their entire initial investment before any of the founders get anything.

The other component of a liquidation preference is the "participation" of preferred shareholders after paying out the liquidation preference. The "participation" explains how much of a share the preferred shareholders get of the remaining money after their liquidation preference is paid.

Non-participating preferred means that the investors do not get any portion of the money left over after getting their liquidation preference. Because investors have the right to convert their shares to common stock (see the following task on Conversion), this basically gives them an option of getting their liquidation preference (usually just getting their original investment back) or getting whatever their share would be if they were treated equally with founders.

Participating preferred means that, in addition to getting their premium, the investors get to participate with the founders when the rest of the money gets distributed. Full participation means the investors get their preference off the top and then get their share of the remaining money just like the rest of the founders. Capped participation means that investors get their premium off the top, and then get their share of the remaining money, up to a certain cap, which is a multiple of their initial investment.

Regardless of their type of participation, the investors can always choose to convert before a sale and get treated the same as common shareholders. They will figure out which makes them the most money and do this.

A great valuation and liquidation preference guide from the VC perspective by entrepreneur-turned-VC Mark Suster://www.bothsidesofthetable.com/2010/07/22/want-to-know-how-vcs-calculate-valuation-differently-f...
It includes a great horror story to remind you just how important it is to pay attention to this stuff. Take away: 3x participating, not ideal.