The Hidden Cost of Participating Preferred: How Founders Lose in “Successful” Exits

Startup exits often make headlines with jaw-dropping numbers — “$100 million acquisition,” “founder cashes out in mega-deal,” “$500 million tech buyout” — conjuring images of instant millionaire founders sailing off into the sunset. To outsiders, these stories represent the ultimate entrepreneurial dream: build something from scratch, scale it with hustle and vision, and eventually secure a life-altering payday. But behind these glossy headlines lies a much darker, less glamorous truth — one that too many founders only discover when it’s far too late.

In countless cases, the numbers celebrated in the press do not reflect the reality of what founders and early employees actually receive. Despite building companies over years with brutal hours, sleepless nights, and personal sacrifice, many walk away from “successful” exits with little more than what they might have earned in a steady job at a tech giant. The reason? Not fraud. Not failure. But a quiet, technical clause buried deep in early investment agreements — one that sounds harmless, even forgettable: participating preferred stock.

This clause, often glossed over in the excitement of raising capital, can ultimately determine who wins and who loses when a company is sold. It’s the difference between walking away a millionaire and walking away with regret. Participating preferred stock creates a financial structure where investors win twice — first by reclaiming their initial investment (sometimes multiplied), and then by taking a cut of the remaining pie — leaving founders with crumbs.

 This article explores what participating preferred means, why it can be so damaging to founders, and how to navigate this hidden minefield.

What Is Participating Preferred Stock and Why Do Founders Opt for It?

In startup financing, founders often agree to terms that may not be in their best interest in the long run, with participating preferred stock being one such example. Participating preferred stock provides investors with the ability to receive a liquidation preference (often 1.5x or 2x the initial investment) and still retain their proportional share of the remaining proceeds, based on their ownership. In essence, investors get paid first, and then they also share in the profits, resulting in a double payout.

Founders opt for participating preferred stock primarily because it is a common compromise in venture capital financing. When raising funds, founders are often focused on securing investment to grow their business and may not fully consider the long-term implications of such terms. The pressure to secure funding may lead to agreeing to terms that benefit investors, especially if these terms are standard in the industry or seem like the only way to raise capital.

The Financial Mechanism of Participating Preferred

The financial mechanism behind participating preferred stock is straightforward but extremely harmful to founders. Here’s how it works in a typical scenario:

• Let’s assume a startup raises $8 million from investors at a $8 million valuation, bringing the total post-money valuation to $16 million. The term sheet includes a 1.5x liquidation preference for the investors, meaning the investors are entitled to receive 1.5x their investment before any other distribution.
• If the company is sold for $25 million, the payout works like this:
  1. Step 1: Investors get $12 million (1.5x of their $8 million investment) first, due to the liquidation preference.
  2. Step 2: The remaining $13 million is then split based on the ownership percentages. If the investors hold 60% of the company, they get 60% of the remaining $13 million, amounting to $7.8 million.
  3. Step 3: The founders (who own 40% of the company) take the remaining $5.2 million, which is 40% of the $13 million.

In this scenario, investors receive $12 million first and then $7.8 million from the remaining proceeds, while the founders only receive $5.2 million. While this might seem fair at first glance, the long-term implications for founders are significant, especially when considering the work, risk, and time they have invested in building the company.

Deeper Analysis: The Hidden Dangers for Founders

Participating preferred stock introduces a misalignment between the interests of investors and founders. Investors, with their guaranteed returns, are incentivized to push for an early exit. This exit locks in their returns, even though a longer wait could yield a much larger outcome for the company.

The real danger emerges in the form of “good but not unicorn” exits—sales in the range of $30 million to $100 million. While these exits can be viewed as success stories, the founders often find themselves with far less than they anticipated due to the liquidation preference structure. In many cases, the founders only realize the full impact of the terms they signed years ago when they are confronted with a sale that leaves them with much less than expected.

Beyond the financial pain, participating preferred stock has deep psychological implications. Founders, who may have sacrificed years of their lives to build the company, are often left feeling betrayed and demoralized when they realize the investors’ terms drastically reduce their payout. This not only affects the founders but also organizational morale, as employees see their equity worth far less than anticipated.

Real-Life Example: Good Technology

The story of Good Technology provides a clear example of how liquidation preferences, including participating preferred, can turn a headline exit into a disaster for founders and employees. Good Technology, a mobile security company, was valued at $1.1 billion at one point but was ultimately sold to BlackBerry for $425 million.

While the company had been successful, the employees who had worked hard for years were shocked to discover that their equity was worth only a fraction of what they expected. Many received just a few thousand dollars despite having been led to believe they owned valuable shares in the company.

In contrast, the investors—who held preferred stock with strong liquidation protections—were able to recover the majority of their capital, leaving little for the founders and employees. This example underscores the devastating impact that participating preferred stock can have, even when a company achieves success.

Liquidity Events and the Role of Liquidation Preference

A liquidity event is an occurrence in which a company is either sold, merged, or liquidated, and the proceeds are distributed among shareholders. Liquidation preferences come into play during these events to determine how proceeds are allocated.

Liquidation preference is essential for protecting investors in the event that the company’s exit is less than expected. However, in a participating preferred structure, the investor is guaranteed a return before anything is distributed to the founders. This arrangement is especially detrimental when the company is sold for a sum that is large enough to represent success but small enough to leave the founders with a disappointing payout.

In many cases, founders can find themselves in a situation where they have worked hard to grow the company, only to realize that the liquidation preference terms they signed years ago severely limit their financial outcome. This creates a scenario where the company’s true potential is overshadowed by the terms set by investors.

Types of Liquidation Preference

Liquidation preferences are generally classified into two types:

1. Non-Participating Preferred Stock: In this structure, investors can either take their liquidation preference (the amount they originally invested) or convert to common stock and participate in the distribution based on ownership. They cannot do both.
2. Participating Preferred Stock: In this structure, investors receive their liquidation preference first (often 1.5x or 2x their original investment) and then participate in the remaining proceeds based on their equity stake. This results in a double payout, which significantly dilutes the amount available for founders and employees.

While participating preferred stock can be advantageous to investors, it poses a significant financial and psychological burden on founders.

Current Trends in Liquidation Preference

In recent years, there has been a noticeable shift in venture capital investing trends. A growing number of deals are now including fewer participating preferred terms, signaling a change in investor behavior and risk appetite.

Q4 2022 data indicated a decline in the use of participating preferred terms across various stages of investment, including early, later, and venture growth stages. Early-stage investments saw a marked decrease, with only 11.8% of deals featuring participating preferred stock by Q4 2022. This shift is likely a response to the changing risk profile and growing confidence in the start-up ecosystem, signaling that investors are becoming more willing to take on risk and reward based on the long-term potential of a business rather than securing short-term returns through liquidation preferences.

Further trends suggest that Q4 2023 will see even fewer deals incorporating participating preferred stock. This shift could be attributed to a more robust startup environment, where investors are increasingly optimistic about company growth and are less inclined to demand investor-favorable terms.

How Founders Can Protect Themselves

Founders can and must take steps to protect themselves when negotiating term sheets. The most important measure is to push for non-participating preferred structures, where investors must choose between their liquidation preference and their ownership percentage, not claim both. If investors insist on participating preferred, founders should negotiate for caps, such as limiting participation to 1.5x or 2x the original investment. It is also essential to watch out for compounding dividends, which, if not controlled, can quietly inflate the investor’s claim on the company over time. Another crucial step is to model multiple exit scenarios during fundraising negotiations. Founders should ask hard questions about what happens at different exit valuations — $30 million, $50 million, $100 million — and understand how much each stakeholder would walk away with under the current terms. Finally, hiring experienced legal counsel who is deeply familiar with venture financing terms is vital. Spending a modest amount on proper legal advice at the early stage can save founders millions of dollars down the line.

Concluding Remarks: The Importance of Negotiation and Protecting Founders

The harmful effects of participating preferred stock on founders cannot be overstated. While this structure can provide significant returns to investors, it often comes at the expense of the people who built the company. Founders are left with less than they deserve, and their morale is undermined, potentially harming future ventures and the startup ecosystem as a whole.

To protect their interests, founders must be vigilant during negotiations. They should seek non-participating preferred stock terms, cap liquidation preferences, and be aware of the potential impact of compounded dividends. Understanding the long-term consequences of these terms is crucial, as a seemingly standard term can leave founders with a fraction of the exit proceeds, despite their years of hard work and risk.

As trends in venture capital evolve, founders must stay informed and advocate for terms that align with their long-term interests. The landscape is shifting, and it’s important for founders to recognize and respond to these changes to ensure they are not unfairly penalized for their success.