A 1x non-participating preference returns the investment or the investor's share, whichever is higher. A participating preference returns the investment and then a share of the rest. The difference is largest at modest exits.
13 min read · Level 4
The waterfall table is the most clarifying thing I know how to build in private investing. It takes clauses written in legal language and turns them into amounts of money at specific outcomes, and once people see the numbers at a modest exit, their view of what a good term sheet looks like usually changes.
An investor puts 10,000,000 into a company at a 40,000,000 post-money valuation, owning 25%. Compare two preference types.
1x non-participating. The investor takes the greater of 10,000,000 or 25% of the proceeds.
1x participating. The investor takes 10,000,000 first, then 25% of what remains.
Exit value Non-participating investor Common Participating investor Common 20,000,000 10,000,000 10,000,000 12,500,000 7,500,000 40,000,000 10,000,000 30,000,000 17,500,000 22,500,000 100,000,000 25,000,000 75,000,000 32,500,000 67,500,000
Working for the participating column at 40,000,000: 10,000,000 + 25% of (40,000,000 - 10,000,000) = 10,000,000 + 7,500,000 = 17,500,000.
The crossover for a non-participating preference is the exit value at which converting to common pays the same as taking the preference: 10,000,000 / 25% = 40,000,000. Below it, the investor takes the preference; above it, they convert.
A 2x non-participating preference returns twice the investment first. At a 20,000,000 exit, a 2x preference on 10,000,000 takes all 20,000,000, leaving common with nothing.
Participation is sometimes capped - for example, participation stops once the investor has received 3x their investment - which limits its effect at large exits.
Because preferences decide outcomes in the most common exits: modest acquisitions rather than huge ones. At very large exits the differences shrink as a share of proceeds; at modest exits they can take most of what common holders would otherwise receive.
It also shows why participation is sometimes called double dipping: the investor gets their money back and still shares in the remainder as if they had not.
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An angel holding 2% as common. Common holders together own 75% of the company in both cases, so the angel's share of the common pool is 2% / 75%, about 2.67%.
Exit Non-participating: common pool Angel Participating: common pool Angel 20,000,000 10,000,000 about 266,700 7,500,000 about 200,000 40,000,000 30,000,000 about 800,000 22,500,000 about 600,000
At a 40,000,000 exit, participation reduces the angel's proceeds by about a quarter - about 200,000 less - without anything else about the company being different.
Treating all 1x preferences as equivalent. Participation and multiples above 1x can change common holders' proceeds substantially at modest exits.
Read whether the preference is 1x or higher, participating or non-participating, and whether participation is capped.
Compute proceeds to preferred and common at a low, middle and high exit value.
For non-participating preferences, divide the preference amount by the investor's ownership to find where conversion becomes better.
Divide your ownership by the common pool's total ownership to find your share of common proceeds.
When evaluating a round's terms, or projecting what an existing stake would return at realistic exit values.
Do not model only large exits. Most private company sales are modest relative to the capital raised, which is where preferences matter most.
Law firms that survey venture financing terms, such as those publishing periodic venture financing reports, have observed that participating preferences, higher preference multiples and other investor-favourable terms become more common when funding conditions tighten, and less common in strong markets.
When capital is scarce, headline valuations can be maintained while terms quietly shift value to investors. Read the preference clauses.
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