Participating vs. Non-Participating Preferred
In our previous discussion, we deconstructed the concept of the liquidation preference—the “buffet line” that determines who gets paid first when a company is sold. We established that these terms are essentially a form of downside protection, intended to ensure that the investors who provided the hard currency receive a return on their capital before the founders and employees, who contributed “sweat equity,” participate in the proceeds. However, simply knowing that an investor has a priority right to their money back is only half the battle. As a senior lawyer in this field, I have seen many founders celebrate a successful exit only to be blindsided by the final payout because they did not grasp the fundamental distinction between participating and non-participating preferred shares.
While liquidation preferences are a core part of the “economics” of a venture deal, the presence or absence of participation is the lever that determines whether your investors are simply protecting their downside or aggressively compounding their upside at your expense.
What is the difference between participating and non-participating preferred?
Non-participating preferred gives investors a choice between getting their money back or converting to common stock. Participating preferred allows investors to get their money back and then also share in the remaining proceeds, increasing their effective return at the founders’ expense.
The Choice: Non-Participating Preferred
In most modern, founder-friendly venture deals, investors receive non-participating preferred shares. This structure creates a clear “either/or” choice for the investor at the time of an exit. When the company is sold, the investor looks at their two options: they can either exercise their liquidation preference to get their original investment back (plus any declared dividends), or they can convert their preferred shares into common stock to receive their pro-rata percentage of the total sale price.
Mathematically, the investor will always choose the path that yields the highest return. If the company is sold for a modest price, the investor will take their “money back” preference. If the company is a “home run” success, the investor will convert to common stock because their percentage of the large exit exceeds the value of their initial check. This structure aligns with the spirit of venture capital: the investor is protected if things go poorly, but they share the success alongside the founders if things go well.
The Double-Dip: Participating Preferred
Participating preferred shares, however, eliminate this choice and replace it with a “double-dip” mechanism. Under this structure, the investor receives their liquidation preference and their pro-rata share of the remaining proceeds as if they had converted to common stock.
If non-participating preferred is an “either/or” proposition, participating preferred is an “and” proposition. The investor first takes their entire investment amount off the top of the exit proceeds. Then, they “get back in line” with the common stockholders to claim their percentage of whatever money is left. This creates a compounding effect that allows the investor to realize a significantly higher return than their ownership percentage would suggest, effectively shrinking the pool of capital available to the founders and employees before they even get to the table.
Why Participation Is Often Downplayed
During the heat of a term sheet negotiation, venture capitalists often minimize the impact of participation. It is frequently framed as a “market standard” or a simple “floor” intended to ensure a minimum return. Because founders are inherently optimistic about their prospects, they often succumb to the “headline number bias,” focusing on a high valuation while ignoring the structural terms beneath it.
Investors may argue that participation only matters in “downside” scenarios, leading founders to believe that in a large exit, the effect will be negligible. This is a strategic distraction. While it is true that participation represents a smaller percentage of a multi-billion dollar exit, venture capital is a game of averages. Most exits are not unicorns; they are modest acquisitions or mergers where every percentage point of the proceeds matters immensely to the founders’ personal outcomes. By accepting participation, you are allowing the investor to “set the terms” to manage their risk while you focus on a “price” that may never actually materialize in your pocket.
Compounding Returns: A Narrative Comparison
To understand how this distinction materially reshapes exit economics, consider two startups, Company A and Company B. Both have identical capital structures: the founders own 80 percent, and an investor owns 20 percent after a $3 million investment. Both companies are eventually acquired for $30 million.
- At Company A, the investor has non-participating preferred shares. At the $30 million exit, the investor realizes that 20 percent of the total price is $6 million. Since $6 million is better than their $3 million preference, they convert to common stock. They take $6 million, and the founders share the remaining $24 million.
- At Company B, the investor has participating preferred sh ares. At the same $30 million exit, the investor first exercises their preference and takes $3 million off the top. This leaves $27 million remaining. The investor then exercises their participation right to take 20 percent of that $27 million, which is an additional $5.4 million. In total, the investor walks away with $8.4 million. The founders are left to share only $21.6 million.
Despite the exits being identical in valuation and ownership percentage, the founders of Company B received nearly $2.5 million less than the founders of Company A simply because of the presence of a participation clause.
→ See the exit math of liquidation preferences in simulated waterfalls.
The Long-Term Impact and Precedent
Founders frequently underestimate participation because they view it as a one-time cost. In reality, the terms you agree to in your first VC-led round will haunt you forever. Venture capital relies heavily on precedent; a Series B investor will almost certainly demand the same rights, privileges, and preferences as the Series A investor.
If you concede participation early on to chase a higher headline valuation, you are effectively “poisoning the well”. You may find yourself sitting at the bottom of a “preference stack” where multiple rounds of investors all get to double-dip before you see a single dollar of upside. In early-stage financings, it is in your best interest to fight for a “clean” term sheet with no participation to ensure that your equity remains a meaningful incentive for you and your team as the company scales.
The distinction between participating and non-participating preferred shares is one of the most fact-specific and economically significant elements of a venture deal. Whether participation is appropriate for your startup depends entirely on your current capitalization table, your anticipated growth trajectory, and your overall negotiation leverage. These terms should never be reviewed in a vacuum but must be analyzed in the context of the entire deal structure to ensure long-term alignment between you and your investors
If you are currently reviewing a seed or Series A term sheet and want to ensure you are not inadvertently signing away your future upside, I invite you to book a consultation. We can perform a detailed review of your specific terms to ensure your interests are protected