Pumped about getting equity at that exciting startup you’re about to join? You should be! But before the ink dries on the contract, you’ll want to make sure you understand all the details of those shares—including the risk attached. No need to stress; we’re here to walk you through the terms to know and the questions to ask. 

Key Takeaways

• Liquidation preferences, participation rights, and cumulative dividends are terms in deals between startups and investors that could affect the value of employee equity (“common stock”).

• These terms can change how the exit ‘pie’ is sliced, sometimes steering more of the proceeds to investors and less to employees than the headline ownership percentages might suggest.

• You can’t change those terms once they are signed, but you can spot them before you accept an offer, or when your current company raises a new round of investment.

Success Without Surprises 

Joining and getting shares in a startup is an exciting moment in any career. And the fine print shouldn’t get in the way of that. We’re here to break down the terms that often show up in deals between startups and investors that could affect your equity. Because every startup employee should feel awesome—not surprised—when that hard earned liquidity event comes around!

Liquidation Preferences

The vast majority of venture capital firms own preferred stock. This means when a liquidity event happens, they have a choice: get back a multiple of their original investment (typically 1x), or convert into common stock and receive their portion of the company’s exit value. When a company exits at a lower or similar valuation than where the VC invested, the VC will usually exercise their liquidation preference and get that multiple (again: typically 1x) back. If the company exits at a higher valuation, the VC will usually convert into common stock and receive their portion of the exit value. The downside scenario – where the company exits at a lower/similar valuation than where the VC invested – is the one in which an employee’s equity can be affected. Consider this example:

Let’s say your company’s only investor is a VC that has preferred stock with a 3x liquidation preference, and they made a $10m investment in your company. At a valuation of $100m, this would give them a 10% share. Now, if your company sells for $100m – i.e. no growth from the valuation at the investor’s initial investment – they would use their 3x preference, giving them $30m. (Because that’s more than they’d get if they converted to common stock, and got 10% of $100m, or $10m). This means that the owners of common stock (i.e. founders and employees) are left to divide the remaining $70m amongst themselves. Not an ideal outcome for employees, and unfortunately it can get much worse.

Participation Rights

Put simply, participation rights are the investor's double dip. If you learn that your company raised money with this term, watch out. Your shares’ value will be impacted when a liquidity event happens.

Take the example deal above, but add participation rights. Not only would the investor pocket $30m (their 3x liquidation preference), they’d also get to “participate” again, taking their 10% ownership slice of whatever’s left. That’s another $7m ($70m * 10% = $7m), leaving only $63m for common stock holders. 

Cumulative Dividends

If participation rights are the double dip, cumulative dividends are the slow burn. This clause lets investors collect interest on their money each year until the company sells, so what the company owes keeps adding up. Most cumulative dividends are considered "paid in kind" (PIK), i.e. instead of getting paid out as cash each year, the amount that would have become cash is kept in the business and instead added to the total liquidation preference once a liquidity event occurs. 

Let’s once more consider our example $10m investment with a 3x preference, but swap out participation rights for a 10% dividend. If it takes five years to exit at a $100m valuation, the VC wouldn’t just get $30m back—they’d also collect another $5m in dividends ($10m * 10% per year * 5 years).

That leaves just $65m for employees. And, in this example, we’re looking only at a flat, annual interest rate. In most cases, cumulative dividends are compounding!  

Cheat Sheet (investor put in $10m, owns 10%, sale price = $100m)

What Knowledgeable Startup Employees Should Ask

The reason these terms make their way into agreements is not because founders and company leaders want to shortchange employees. Rather, they show up primarily when funding is hard to come by. Maybe a product launch slipped, maybe the market cooled off, maybe this is just a particularly risky type of business; in these scenarios, investors hold the cards. Terms like the ones we broke down in this article become the price of keeping the lights on. And to be fair, the VCs negotiating them are likely investing when few others would.

So, before you join a startup, ask the questions that will clarify the true value of your equity:

• Do any investors have liquidation preference? If so, how much is their investment and what's their multiple (2x, 3x...)?

• Do deal terms with VCs include participation rights or cumulative dividends?

• Did a new round add terms that shift payouts? (This one’s for current employees who hear about a new investment).

If red flags start rising, think about tradeoffs. A little more salary and a little less equity can make the risk feel right. It doesn’t always work, but it never hurts to ask.

Joining a startup is one of the most exciting things you can do. By arming yourself with all the information about your company’s capital structure, you can avoid surprises and focus on what truly matters: building the next big thing!