We’ve all done it. Someone’s talking, you have no idea what they’re talking about, and for any number of reasons, you pull the classic smile and nod.
In most social situations, that’s harmless and polite. When discussing a term sheet, it can be one of the most expensive things a founder does.
A founder I work with did exactly that. Their investor introduced the term participating preferred, called it “standard,” and the founder smiled and nodded, having no clue what it meant. Nothing was signed, but the founder felt scared to walk it back. They worried that asking questions would make them look desperate or inexperienced.
If you’ve raised money, you’ve probably been in that seat.
If you’re raising money, you’re probably nervously smiling and nodding, as you’re all too familiar with the above story.
However, let’s keep you from smiling and nodding about at least one thing right now: here is what “participating preferred” means.
What participating preferred actually does.
When the company exits, preferred investors get their money back first, ahead of common shareholders like founders and employees. That’s the “preferred” part. With participating preferred, they then also take their ownership share of whatever’s left. That’s the “participating” part. They participate in the leftovers. So, they get paid twice: once off the top, then again alongside everyone else. That’s why it’s called double-dipping.
Here’s what that looks like.
Say an investor puts in $2M for 20% of the company, and you sell for $20M (let’s go!).
Under 1x non-participating, the investor takes the greater of their $2M back or 20% of $20, so they take $4M.
Under participating, the investor takes $2M off the top, plus 20% of the remaining $18M, so they take $5.6M.
That $1.6M difference comes out of your pocket, your cofounders’, and your team’s.
It’s not standard
At seed, the market norm is a 1x non-participating preference. No double-dipping! If an investor is asking for participating preferred at seed stage, they are either using it as a negotiating position or a bid for unusually favorable terms.
Either way, “standard” is the wrong word.
Agreeing can have ramifications beyond the round, too. Later investors tend to ask for whatever earlier investors got, so aggressive terms stack up round after round. Or a new lead insists on “cleaning things up” before writing a check. And, in general, to anyone reviewing your cap table, it can signal that you didn’t understand what you signed or didn’t have the leverage to negotiate.
What pushing back actually looked like
Rewind to the founder from earlier. After we walked through it, they went back to the investor. They were nervous. It felt like risking the relationship, maybe the round. Here’s roughly what they said:
“I read that participating preferred isn’t standard at my stage. Can you help me understand why you think it’s appropriate here? Would you be open to the standard [1x non-participating] instead?”
Did the investor storm off and sabotage all future investment efforts, leaving the company doomed? No.
Instead, the founder walked away with market-standard terms, a more standard cap table, and something harder to quantify: the knowledge that asking a question isn’t adversarial. An investor worth working with will probably expect it.
Smiling and nodding might help you close a round a little faster and get you some cash in the short term. It can cost you much more in the long run.
Something on your term sheet that doesn’t make sense is your cue to start asking questions.
Know a founder who’s raising right now? Send this to them. They might be mid-nod.