How Participating Vs. Non-Participating Preference Shares Change Founder Outcomes On Exit

The ratio of participating vs. non-participating preference shares on a company’s cap table influences outcomes for founders on exit. Exits can take the form of mergers and acquisitions (M&A). Or, when the company goes public with an Initial Public Offering (IPO).

Participating and non-participating provisions in your investment agreements determine the proceeds investors will receive when that happens. More importantly, they determine the money remaining for the cofounders after investors and other stakeholders receive their share.

As a rule, non-participating shares are more founder-friendly and secure your stake in the company you’ve built. However, despite the potential for dilution, founders may agree to offer investors a degree of participating preference. How does that impact your outcomes? Let’s take a look.

Understanding What Liquidation Preference Is

Preference shares or shares with a liquidation preference provision are essentially safeguards for investors who provide capital to a startup. Many founders agree to these provisions to provide investors with an additional layer of security.

Typically, companies operating in high-risk sectors, highly volatile markets, or with low valuations need to offer additional incentives. That’s how they convince investors to back them with capital. The liquidation preference clause entitles investors to recoup their capital ahead of other stakeholders.

In the event of a liquidation, investors can receive their money before founders, employees, common shareholders, and other investors. They receive priority treatment and assurances of payouts in the event of bankruptcy or a premature sale.

The liquidation preference clause is a safeguard against the risk that the proceeds will be insufficient to allow investors to recover their capital. It provides assurance that they will receive at least some of their money back. Founders agree to this provision because it enables them to raise funds.

Both parties negotiate the clause in detail to ensure a fair allocation of risk between the founders and investors. Typically, the liquidation preference clause features in venture capital contracts, promissory notes, and hybrid debt instruments. Basically, in structured private capital funding transactions.

Why do founders need to be cautious? Liquidation preference clauses can take different forms, and each can affect founders’ outcomes in exits. Aside from participating vs. non-participating preference shares, they can also include conditions such as The Multiple, Seniority, and capped participation.

The risk of getting a smaller portion of the proceeds from the company’s sale is just one of your worries. You should also be concerned about how new investors view the clauses and the impact on employee morale and motivation.

Understanding How Participating Preference Shares Work

Investors holding participating preference shares allow them to get back their capital on priority—but with an added perk. They can participate in the remaining proceeds on a pro rata basis or per any other clauses in the agreement. For instance:

• The option to convert preferred shares into common stock and sell at the current market price. Investors can choose the option that delivers higher returns. This “double-dip” clause reduces the proceeds available to founders and other stakeholders. Investors can walk away with most of the money.
• Investors may claim accrued dividends if the investor agreement includes the provision.
• The Multiple clause enables investors to claim a pre-determined multiple of the value of their preferred stock. While the standard is 1x, the multiple can be 2x, 3x, or any other as outlined in the investor agreement. If you’ve agreed to a multiple, expect to be left with only a small share of the proceeds.
• The seniority preference clause determines the hierarchy or priority with which investors get back their capital. Typically, the lead investor and seed-round investors get top priority. Next are the Series A, B, and C rounds, in the order in which they invested in the company. Lead and seed investors bear the greatest risk when backing a nascent startup. Thus, they should be paid first. On the other hand, later-stage investors may provide larger capital commitments to support the company’s accelerated growth. Or, to keep the company operational during crises, such as an economic downturn or uncertain geopolitical conditions. Although striking a balance is critical to securing funding, you may find that the remaining funds are insufficient to share. Founders are sometimes left with nothing for their time and effort in building the company.

Understanding How Non-participating Preference Shares Work

Given a choice between participating vs. non-participating preference shares, the latter option secures founder interest on exit. Investors can elect to recover their invested capital at a single multiple, in accordance with the standard hierarchy. That is, aside from accrued dividends, if agreed.

Alternatively, they can convert their preference shares into common stock and receive a proportional share of the proceeds. This process, also called a “single dip,” is fairer and yields more predictable outcomes for the founders. You’ll know exactly what to expect when the company liquidates.

Typically, investors evaluate options to determine which offers the highest returns and choose accordingly.

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Let’s Try an Example

In Scenario 1

The company has a poor outcome and is sold or liquidated at a low price. This price is less than the total invested capital through preferred shares. In that case, investors recover the maximum capital thanks to the downside protection. Founders, employees, and other shareholders get nothing.

Company ABC raises funding and issues preferred shares with a $8M liquidation preference. These preferred shares comprise 50% of the total capital stock. But the preferred shares are participating. The company is sold for $12M. As preferred stockholders, investors recover their $8M.

In addition, they receive 50% of the remaining $4M since they own participating preferred shares. In this way, the total returns they claim are [$8M + 50% of $4M = $10M]. The founders and other stakeholders must share the remaining $2M of the sale proceeds.

However, if investors have a 2x multiple on participating preferred shares, they can claim the entire $10M. In that case, common stockholders will lose their initial investment, and cofounders will receive nothing from the sale proceeds.

In Scenario 2

The company is moderately or strongly successful. In that case, investors get preferential treatment and recover their invested capital. The founders and other stakeholders share the remaining proceeds in proportion to their vested equity stakes.

Company XYZ raises funding and issues preferred shares with a $8M liquidation preference. Again, these preferred shares comprise 50% of the total capital stock. However, the preferred shares are standard and non-participating. The company is sold for $12M.

Here, investors may exercise their preferred share rights and claim their shares as a priority. Or, they can convert their preferred shares into common stock and share in the proceeds just as other shareholders. If investors convert into common stock, they’ll receive 50% of $12M, totaling $6M.

But, as preferred stockholders, investors recover their $8M. This $8M is higher than the 50% share of $12M, which adds up to $6M. Thus, the remaining $4M is distributed among the cofounders and other stockholders, including employees owning option pools.

Let’s assume the company is highly successful and is sold for $20M. If investors exercise their preferred share rights, they get back $8M. This is lower than 50% of the $20M sale price. In that case, they can convert their preferred shares into common stock and get $10M.

Compare the two scenarios in which the proceeds from the sales of Company ABC and Company XYZ are similar. The differences in participating vs. non-participating preference shares significantly affect the founders’ outcomes, reducing their returns by half.

How Participating Preference Shares Impact Founders

As long as the company has a successful exit via an attractive acquisition or goes public, founders will benefit. However, even if the company is only moderately successful, the participating preference share rights significantly affect their outcomes.

As explained in Scenario 1, the ability to double-dip and claim additional shares beyond their stake benefits investors. But it increases the risk that founders, employees, and common shareholders will receive no returns.

This risk is compounded when founders issue preferred shares with participating rights to investors in subsequent funding rounds. Each round, when combined with the seniority clause, results in cumulative dilution, reducing the stakes of the founders and common shareholders.

How Participating Preference Shares Impact Investors

When investors negotiate terms and consider participating vs. non-participating preference shares, they’ll likely look for solutions to offset their risks. Participating rights entitle them to recover their investment if the early-stage startup goes bankrupt or liquidates.

However, if the company scales to later stages, investors receive proportional returns for backing the company and assuming high risk. The anticipation of returns enables them to maintain their stake in the company over an extended period.

Investors also use participating clauses to mitigate dilution risk, given that they are the company’s lead investors. As the company grows, you’ll issue option pools to employees and raise subsequent funding rounds. Each round further dilutes the lead investors’ stake and participation offsets that risk.

Do you still have questions about what are preference shares and how they work? Check out this video in which I have explained them in detail.

How Non-Participating Preference Shares Impact Founders and Investors

As you’ve likely noted in the above scenarios, non-participating preference stock is more favorable for founders and other stakeholders. You’ll avoid the risk of double-dipping, in which investors claim far more than their fair share. Thus, founders seek a middle ground that benefits both parties.

Non-participating preference shares secure investors’ risks while also allowing them to participate in the company’s success. The liquidation preference clause allows them to recover their initial capital if the company is liquidated at a low price.

On the other hand, if the company is sold at a premium or goes public, investors can convert their shares into common stock. This provision enables them to participate in the company’s success when the exit value far exceeds the conversion limit.

The non-participating option in preference shares is mutually beneficial, which motivates both parties to seek higher valuations. Founder, investors, employees, and all other stakeholders fully understand that the company’s upside is advantageous for their interests.

Furthermore, organizing the cap table structure and calculating the share of proceeds are straightforward and less complex. This alignment of interests and simplicity has prompted more venture capitalists to go with non-participating shares.

Competition among investors to attract top-tier, high-performing entrepreneurs and the opportunity to invest in potential unicorns are incentives. Investors are keen to work with savvy founders who have a successful track record and know how participating vs. non-participating preference shares work.

This is why founder-friendly terms have become the underlying differentiator in the contemporary startup ecosystem and business landscape.

Other Solutions

Yet another solution is capped participation. In this case, investors holding participating preference shares get priority in recovering their invested capital. In addition, they can claim a pro-rata share of the remaining proceeds, but only until they reach a pre-determined cap.

Once this cap is reached, investors’ shares convert into common stock, and they receive returns just as other shareholders. Aside from capped participation, also consider the pari passu provision, which assigns the same level of seniority to all investors.

Regardless of the round in which they invested, investors can expect the same returns. This strategy secures employees’ rights and option pools, safeguarding their interests and motivation. As a final safeguard, don’t overlook the dividends you’ll pay on the shares. Factor them into the final calculations.

In Conclusion

Before issuing participating vs. non-participating preference shares, ensure that you understand their implications on the dilution of ownership stake. In an attempt to attract capital, founders often make the critical mistake of agreeing to terms that are detrimental to their and the company’s interests.

Always remember that issuing too many participating preference shares to early or lead investors deters later-stage investors. The reverse is also true. Lead investors may hesitate to invest if they believe founders will offer participating rights in later funding rounds.

Given that funding is the lifeblood of a nascent company, you’ll need to establish the right practices at the onset. Work with an expert consultant who can guide you in the right direction. Get advice on how to structure early funding rounds so that they are robust foundations for the later-stage capital raising.

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