A preference is a queue. When the company is sold, the preferred shareholders are paid before the common shareholders, and the terms of that priority decide the split at every exit value except the very large ones.
Return to Redwood Vector, whose Series A bought 8,000,000 preferred shares at $1.00 against 10,000,000 common, giving the preferred 44.4444% on an as-converted basis and a $8 million liquidation preference at 1x.
Participating vs non-participating liquidation preference
Under a 1x non-participating preference the holder chooses, at exit, between taking the $8 million preference and converting to common for 44.4444% of the proceeds. Conversion wins when 0.444444E exceeds $8 million, which is E above $18.00 million. That indifference point is the post-money valuation, and it always is for a 1x non-participating preference bought at cost, which is a useful sanity check on any preference table you are handed.
Under a participating preference the holder takes the $8 million and then shares in what is left, at 44.4444%. Under a participating preference capped at 2x, the total the holder may take by that route is limited to $16 million, after which converting becomes the better option.
| Exit | Non-participating: preferred | Non-participating: common | Participating 2x cap: preferred | Participating 2x cap: common |
|---|---|---|---|---|
| $6m | 6.000 | 0.000 | 6.000 | 0.000 |
| $12m | 8.000 | 4.000 | 9.778 | 2.222 |
| $18m | 8.000 | 10.000 | 12.444 | 5.556 |
| $26m | 11.556 | 14.444 | 16.000 | 10.000 |
| $36m | 16.000 | 20.000 | 16.000 | 20.000 |
| $60m | 26.667 | 33.333 | 26.667 | 33.333 |
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How do you read the exit table?
Read the last two rows first. Above $36.00 million the two structures pay identically, because the cap has stopped binding and the holder converts in both. Read the top row next: at $6 million the company is worth less than the preference, so the preferred takes everything and the founders take nothing, whatever the cap table says.
The entire economic difference between the two structures lives in the middle band, and it is worth $4.44 million at both the $18 million and $26 million exits. At $26 million the common shareholders receive $14.44 million under the non-participating structure and $10.00 million under the capped participating one, on the same sale of the same company.
That $4.44 million does not vanish. It moves from the founders' column into the preferred holder's.
How do you find the break-even exit values?
Two boundaries are worth memorising as computations rather than facts. The cap first binds at the exit where the participating payout reaches the cap, here 8 + 0.444444(E − 8) = 16, so E = $26.00 million. And conversion becomes preferable at the exit where as-converted value reaches the cap, 0.444444E = 16, so E = $36.00 million.
The founders' negotiating instinct is usually "get the multiple on the preference down", and it is usually misdirected. A 1x participating preference is worse for common in the realistic exit band than a 1.5x non-participating one, because participation reaches into every dollar rather than a fixed first slice. Ask which structure applies, then ask for the cap, then compute the two boundaries. A term sheet that resists all three questions is telling you something.
What does seniority change?
Seniority is the term everything above has quietly assumed away. Where multiple preferred rounds exist they may rank pari passu (sharing the available proceeds in proportion to their preferences) or stacked (Series C paid in full before Series B sees anything). In a disappointing exit, stacked seniority is often the term that decides whether an earlier investor and the founders receive anything at all, and it is negotiated round by round, usually by the newest and most powerful investor in the room.