Liquidation Preferences: Participating vs. Non-Participating Explained

When a company raises venture capital, liquidation preferences determine how investors and common shareholders split proceeds during a sale or IPO. Here's the key takeaway: liquidation preferences ensure investors get paid first, but the structure - participating or non-participating - can drastically affect payouts for founders and employees.

• Participating Preferred Stock: Investors claim their initial investment (e.g., 1x) plus a share of remaining proceeds. This "double-dip" reduces payouts for founders and employees, especially in smaller exits. Sometimes, a cap limits how much investors can double-dip.
• Non-Participating Preferred Stock: Investors choose between taking their liquidation preference (e.g., 1x) or converting to common stock for a proportional share. This setup avoids the "double-dip", making it more favorable for founders.

Quick Example:
If a company sells for $2M and an investor owns 25% with $500K invested:

• Participating: The investor gets $500K first, then 25% of the remaining $1.5M ($375K), totaling $875K.
• Non-Participating: The investor either takes $500K or converts for 25% of $2M ($500K). No double-dip.

Key Stats:

• 97% of non-participating shares in 2024 used a 1x multiple.
• 84% of participating shares also used a 1x multiple, but these are becoming less common due to founder-friendly trends.

Quick Comparison

Takeaway

Non-participating preferred stock is now the standard in U.S. venture deals. It balances investor protection with fairer outcomes for founders. Founders should aim for 1x non-participating preferences and avoid participating terms when possible. If participation is unavoidable, negotiate caps to limit the impact.

How Liquidation Preferences Work

Liquidation preferences act as a contractual safety net for investors, ensuring they get paid before others during a company's exit. Essentially, they establish a payout hierarchy: preferred stockholders receive their share before common stockholders.

At the heart of liquidation preferences is the preference multiple. This determines how much investors are entitled to before others see any proceeds. The most common setup is a 1x liquidation preference, meaning investors get back exactly what they put in. However, higher multiples exist - like 2x, where investors receive double their investment, or 3x, where they get triple.

When a company is sold, proceeds are distributed through a preference stack. Payments are made in order of investment rounds, with later rounds often taking precedence. Only after all preferred stockholders receive their guaranteed payouts do common stockholders get a share of what’s left.

Here’s a simple example: A startup raises $200,000 in a Series A round with a 1x non-participating liquidation preference and has 800,000 common shares outstanding. If the company sells for $500,000, the Series A investors are paid their $200,000 first. That leaves $300,000 for the common shareholders, which works out to about $0.375 per share.

Now, let’s look at what happens if the company sells for $1.5 million. Preferred stockholders have the option to either take their liquidation preference or convert their shares to common stock and claim a proportional share of the total proceeds. If they stick with the preference, they receive $200,000, leaving $1.3 million for the common shareholders ($1.625 per share). If they convert, all 1 million shares (preferred + common) split the $1.5 million equally, resulting in $1.50 per share. Investors will always choose the option that gives them the highest return, ensuring they’re never locked into a less favorable outcome.

The preference multiple plays a big role in determining payouts. For instance, with a 2x liquidation preference on the same $200,000 investment, investors would be guaranteed $400,000 before common shareholders receive anything. While this higher multiple offers more protection for investors, it can significantly reduce payouts for founders and employees, especially in smaller exit scenarios.

Interestingly, 97% of non-participating shares in 2024 carried a 1x multiple, reflecting a shift toward terms that are more favorable to founders. On the other hand, 84% of participating preference shares also used a 1x multiple, though participating structures introduce additional complexities, which will be covered later.

Another factor to consider is the seniority structure. This determines the order in which investors are paid and can sometimes leave early investors with reduced payouts - or even nothing - if the proceeds aren’t enough to cover all preferences.

Liquidation preferences influence every exit event, whether it’s a profitable sale or not. If a company sells for less than the total raised capital plus the preference multiples, common shareholders might walk away with little or nothing, despite the company’s overall success.

1. Participating Preferred Stock

Participating preferred stock offers investors a unique advantage in exit scenarios. Unlike non-participating shares, these investors don’t have to choose between their liquidation preference and converting to common stock - they get the benefit of both.

Payout Structure

Participating preferred stock operates differently from standard liquidation preferences. Here’s how it works: investors first claim their liquidation preference and then share in the remaining proceeds alongside common shareholders. This sequential payout structure can significantly impact how exit proceeds are distributed.

Let’s break it down with an example. Imagine a company raises $500,000 in Series A funding with a 1x participating liquidation preference. Later, the company is sold for $2 million. First, the Series A investors receive their $500,000 liquidation preference. Then, they share in the remaining $1.5 million based on their ownership percentage. If the Series A investors own 25% of the company on an as-converted basis, they would receive an additional $375,000 (25% of $1.5 million). In total, their payout would be $875,000 - 44% of the exit proceeds, even though they only own 25% of the company.

Some participating preferred stock comes with a participation cap, which limits the total payout investors can receive. For example, with a 3x cap, investors can only receive up to three times their initial investment. Once this cap is reached, they effectively convert to common stock for any additional proceeds.

Impact on Founders

While this structure is favorable for investors, it can have a significant downside for founders and employees. Participating preferences often reduce payouts for common shareholders, especially in moderate exit scenarios. The double-dip effect means investors take both their liquidation preference and a share of the remaining proceeds, leaving less for the common stock pool.

For example, if founders and employees collectively own 60% of the company on a fully diluted basis, they would receive 60% of the proceeds after liquidation preferences in a non-participating structure. With participating preferred stock, however, investors claim their preference first and then take a share of the remaining proceeds, which can reduce founder payouts by 20-40% in many cases.

The situation becomes even more challenging when multiple rounds of participating preferred stock are issued. Each round takes its liquidation preference first, creating a cumulative dilution effect that further erodes the payouts for common shareholders.

Investor Motivations

Participating preferred stock aligns with investors’ goals of balancing risk protection with the opportunity for upside. In smaller exits, investors are assured of recovering their initial investment through the liquidation preference. In larger exits, they benefit from the company’s success by participating in the remaining proceeds.

This structure is particularly appealing to investors because it helps them maintain their economic stake in the company over time. As companies issue employee stock options and raise additional funding rounds, early investors see their ownership diluted. Participation rights ensure they continue to benefit proportionally from the company’s growth and success.

Frequency in U.S. Deals

In recent years, participating preferred stock has become less common in venture deals. This shift reflects a broader trend toward more founder-friendly terms. While participating structures were more prevalent during the dot-com boom and the years following the 2008 financial crisis, they now appear in a smaller percentage of deals.

The decline in these structures is largely due to increased competition among investors. Many venture capitalists have moved away from participating preferences to attract top-tier entrepreneurs who are well-versed in how these terms impact long-term outcomes. As a result, founder-friendly terms have become a key differentiator in the venture capital landscape.

2. Non-Participating Preferred Stock

Non-participating preferred stock gives investors a straightforward choice: they can either claim a fixed liquidation preference or convert their shares to common stock to receive a proportional share of the exit proceeds. This "either-or" setup stands in contrast to participating preferences, where investors receive both a liquidation preference and a share of the remaining proceeds. In the U.S., non-participating preferred stock has become the standard in most venture capital deals.

Payout Structure

With non-participating preferred stock, investors must pick one payout option. They can either:

• Take their liquidation preference, typically 1x their original investment.
• Convert their preferred shares into common stock, receiving a percentage of the total sale proceeds based on their ownership stake.

Here’s an example: an investor with a 1x non-participating preference and a 20% ownership stake would receive $1 million in a $3 million exit. However, if the company sells for $8 million, converting to common stock would yield $1.6 million. Naturally, investors choose the option that provides the better return, and conversion becomes attractive only when the exit value surpasses the break-even point.

Impact on Founders

Non-participating preferred stock tends to be more favorable for founders because it avoids the "double-dipping" seen in participating structures. In successful exits where investors convert to common stock, the remaining proceeds are distributed proportionally, creating a cleaner split for founders and employees.

Using the earlier example, if a company sells for $8 million and investors convert their 20% stake, founders and employees with 60% ownership would walk away with $4.8 million. This outcome is far better than what they’d receive under a participating structure. However, challenges arise when exit proceeds are close to or below the total liquidation preferences. The impact becomes more pronounced with higher liquidation multiples. While most non-participating shares in 2024 carried a 1x multiple, some deals included 2x or 3x preferences, which significantly increase the conversion threshold and reduce payouts for founders in moderate exits.

Investor Motivations

Non-participating preferred stock strikes a balance between protecting investors’ downside and allowing them to benefit from the company’s success. The liquidation preference ensures that investors recover their initial investment if the exit disappoints, while the conversion option lets them fully participate in upside scenarios when the exit value exceeds the conversion threshold.

This structure aligns with the venture capital strategy of accepting some losses in exchange for large returns on successful investments. Once the exit value surpasses the conversion threshold, both investors and founders are incentivized to maximize the company’s value, as the proceeds are shared proportionally. This simplicity and alignment of interests have made non-participating preferred stock the go-to structure in U.S. venture deals.

Frequency in U.S. Deals

In today’s venture capital landscape, non-participating preferred stock - especially with a "1x, non-participating" liquidation preference - has become the standard for early-stage investments. This shift reflects a broader trend toward founder-friendly terms, driven by the competitive nature of venture investing.

For many entrepreneurs, non-participating structures are now baseline expectations. Participating preferences are often seen as a warning sign, making it harder for investors to secure deals if they insist on less favorable terms. This has solidified the dominance of non-participating preferred stock in the U.S. market.

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Advantages and Disadvantages

After breaking down payout structures in detail, let’s explore the pros and cons of each approach in venture capital deals for both investors and founders.

Participating Preferred Stock

For investors, participating preferred stock offers a significant advantage: it provides downside protection while allowing for "double-dip" returns. Essentially, investors recover their initial investment first and then share in any remaining proceeds.

For founders, the story is less favorable. This structure reduces their exit proceeds and increases ownership dilution since investors benefit from both the liquidation preference and their proportional share of the remaining payout.

Non-Participating Preferred Stock

Non-participating preferred stock has become the standard in U.S. venture deals. For investors, it ensures downside protection through the liquidation preference while also offering upside potential if they convert to common stock. The "either-or" mechanism simplifies calculations and makes exit negotiations more straightforward.

For founders, this structure is more favorable because it avoids the double-dip payouts seen in participating preferred stock. As highlighted earlier, it provides a cleaner exit allocation, which can simplify planning and make the process less burdensome.

Key Differences at a Glance

Here’s a quick comparison of the two structures:

Strategic Considerations

The choice between these structures can significantly influence exit outcomes. Often, the final terms reflect the negotiating strength of each party. In today’s competitive venture market, about 33.3% of deals involving participating preferred shares include caps on participation rights, signaling founders’ push for more balanced agreements.

Phoenix Strategy Group, known for advising growth-stage companies, helps founders navigate these decisions. Their fractional CFO services include detailed modeling of exit scenarios, enabling founders to weigh the implications of preferred stock terms.

For founders negotiating participating preferred stock, the best strategy often lies in building leverage through consistent performance. Companies that hit their growth milestones and demonstrate strong results are better positioned to negotiate non-participating terms or, at the very least, secure caps on participation rights. Ultimately, a solid business foundation is a founder’s most valuable bargaining tool.

Conclusion

Liquidation preferences play a critical role for U.S. growth-stage founders navigating the complexities of venture capital agreements. Deciding between participating and non-participating preferred stock can significantly influence your exit proceeds and the long-term value of your equity.

Non-participating preferred stock is widely regarded as the standard in the market. It offers investors protection on the downside while ensuring founders retain a more equitable share of the exit proceeds. Its "either-or" structure avoids the costly double-dip scenario associated with participating preferred stock, which can be particularly burdensome in moderate exit outcomes.

When negotiating these terms, founders should prioritize a few key areas. First, avoid participating preferred stock whenever possible, as it can drastically reduce your share of exit proceeds. If participation rights are unavoidable, push to include caps that limit investors' upside. Second, aim to keep liquidation preference multiples at a standard 1x level, as higher multiples can erode your returns and complicate future funding rounds.

Given the intricacies involved, seeking expert guidance is crucial. Companies that take the time to model various exit scenarios during negotiations gain a clearer understanding of the financial impact of their terms. This preparation enables more informed decisions about their capital structure.

Support from professionals can make a significant difference. Phoenix Strategy Group offers fractional CFO services that help growth-stage companies navigate these pivotal decisions. With their expertise in financial modeling, fundraising strategies, and exit preparation, founders are better equipped to evaluate liquidation preference terms and negotiate with confidence.

Ultimately, your ability to negotiate favorable terms depends on your performance. Companies that consistently hit milestones and demonstrate strong growth metrics hold more leverage at the bargaining table. By building a solid financial foundation and maintaining clear insights into your unit economics and cash flow, you can align liquidation preferences with a broader strategy for scaling, securing funding, and achieving a rewarding outcome for all stakeholders.

FAQs

How do liquidation preferences affect payouts in smaller exits?

When it comes to smaller exit scenarios, liquidation preferences play a big role in deciding how the proceeds are divided. These preferences give investors holding preferred stock the right to get paid first - often based on a predetermined multiple - before any money goes to common shareholders, such as founders and employees.

In cases where the exit value is on the lower side, this priority can drastically cut down or even completely wipe out payouts for common shareholders, particularly if the liquidation multiples are high. Knowing the details of these terms during negotiations is key to protecting the potential returns for everyone involved.

How can founders negotiate better liquidation preference terms with investors?

Founders have a chance to secure better outcomes during an exit by pushing for non-participating preferences. This approach ensures they keep a larger share of the proceeds. Another option is to negotiate caps on participation, which can limit the downside risk and create a fairer distribution between founders and investors.

Equally important is aligning with investors on shared long-term objectives. By understanding market norms and preparing for negotiations, founders can navigate the complexities of liquidation structures. This preparation helps safeguard their equity and financial interests while striking a balance that works for all parties involved.

Why is non-participating preferred stock commonly used in U.S. venture capital deals, and how does it benefit founders?

Non-participating preferred stock is a common feature in U.S. venture capital deals because it provides investors with a straightforward and reliable payout structure. With this type of stock, investors are guaranteed either their original investment amount or their proportional share of the exit proceeds - whichever is greater - without claiming additional funds from the remaining liquidation pool.

For founders, this setup offers a significant advantage. It helps maintain ownership equity and allows them to maximize their potential returns during an exit. Since investors don't receive payouts beyond their initial preference, founders can keep a larger share of the upside when the company performs well. This combination of protecting investors while remaining favorable to founders has made non-participating preferred stock a go-to choice in the venture capital world.

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