Expose the Real Impact of Liquidation Preferences Before Signing
Many founders sign term sheets without truly understanding what happens to their ownership if things don’t go as planned. Liquidation preferences—especially multiple and participating ones—are complex, often written in legalese, but their consequences are very real. Think of preferred investors claiming their money back first (plus sometimes more), before anyone else—then, and only then, does everyone else share the pie.
For example, if you sell your company at a low price, you might get nothing at all, while investors recoup their original investment (or more) due to these preferences. Participating preferred adds another layer—the investor takes their original capital back and then also gets their ownership share of the leftovers. This is sometimes capped (so after a certain point they must convert to common), but uncapped participation is a tough term for founders.
By building a simple spreadsheet or using an online calculator, you can see at a glance whether a sale for $15 million makes employees a windfall, or leaves them empty-handed while the investor takes all. This exercise isn’t just academic: it reveals trade-offs between protecting downside (which most investors see as fair) and ensuring founders have reason to work for a tough win. The science here draws on incentive alignment and behavioral contract theory—poorly understood payoffs drive frustration, but clear, shared models spark buy-in and focus.
Take the time to map out the math, running scenarios that show how each combination of preference, participation, and exit price affects your possible payout, then bring your team into these calculations so everyone is on the same page. Press for terms that protect but don’t punish—and don’t be shy about showing your negotiation partners how these numbers would play out in hard and lucky cases alike. Running these exit models today lets you sleep better tomorrow.
What You'll Achieve
Develop an internal sense of fairness and realism about company outcomes. Externally, gain stronger negotiating leverage, foster trust with your team, and avoid later disappointment or miscommunication about rewards.
Model and Explain Deal Outcomes Across Exit Scenarios
Build a simple spreadsheet of ownership and preference terms.
Input current cap table, investors' preferred shares, multiples (1x, 2x, participating, etc.), and what everyone owns after the round.
Calculate returns for investors and founders at multiple sale prices.
Test scenarios: a low exit, a great exit, and an in-between exit. Show exactly who gets paid, and how much.
Communicate impacts with all co-founders and early employees.
Run through the numbers as a group—not just in private. See how different terms affect each party if the business is sold below, at, or above the investment threshold.
Negotiate to minimize deep downside protections or caps.
Push for nonparticipating preferences and single triggers where possible, or for participation caps that are fair in up-side exits.
Reflection Questions
- Do you understand all the layers of preference and how they affect your potential earnings?
- How would you explain these terms in plain language to a teammate?
- When faced with a lower-than-desired exit, how do you balance investor protection with motivating the team?
- What terms feel fair for both sides considering the risks taken?
Personalization Tips
- If your family planned to split prize money after a competition, you’d want to see exactly how the winner, the runner-up, and the coach divide it before agreeing to the plan.
- On a school project, making reward deals ahead of time (including in bad-case scenarios) keeps everyone clear on their possible outcomes if things go well or poorly.
Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist
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