Understanding Participating v Non Participating Preferences: A Cheat Sheet for HealthTech Founders

Shareholder agreements for healthtech startups often include preferred shares, which have rights that are superior to common shares. Within preferred shares, the most critical distinction for founders to understand is between participatingand non-participating preferences, as this directly impacts how much money investors receive during a liquidity event (like an acquisition or IPO) and consequently, how much is left for the founders and common shareholders.

Non-Participating Preferred Stock 🤝

This is the most common and founder-friendly type of preferred stock.

How it Works: When a company is sold, non-participating preferred shareholders have a choice:

Get their money back: They can take their initial investment back, plus any accrued dividends.
Convert to common stock: They can convert their preferred shares into common shares and get their proportional share of the sale proceeds, just like everyone else.

Payout Logic: They will choose whichever option gives them a higher return. For example, if an investor put in $10 million for 20% of the company and the company sells for $100 million, they will get $20 million by converting to common stock (20% of $100 million), not just their initial $10 million back.

The Founder's Takeaway: This model means investors get a return or a proportional share of the equity, but not both. This leaves more value for founders and common shareholders, especially in a high-value exit.

Participating Preferred Stock 💰

This type of preferred stock is less common for early-stage companies and is generally more investor-friendly.

How it Works: Participating preferred shareholders get their initial investment back first, and then they get to participate in the remaining sale proceeds along with the common shareholders, based on their ownership percentage.

Payout Logic: The investor's payout is a two-step process:

Liquidation Preference: The investor gets their initial investment back off the top.
Participation: After the initial investment is returned, the remaining money is distributed as if the preferred shares had converted to common stock. The investor gets their proportional share of this remaining pot.

Example: An investor puts in $10 million for 20% of the company, and the company sells for $100 million.

Liquidation Preference: The investor gets their $10 million back. This leaves $90 million for distribution.

Participation: The investor then gets their 20% of the remaining $90 million, which is $18 million.

Total Payout: The investor's total payout is $10 million (liquidation preference) + $18 million (participation) = $28 million.

The Founder's Takeaway: This structure is less favorable for founders because investors double-dip, taking both their money back first and a proportional share of the remaining value. It significantly reduces the size of the payout for common shareholders, particularly in moderate-to-low-value exits.
 
Key Differences and Founder's Action Plan

Negotiate for Non-Participating: Always push for non-participating preferred stock. It is the industry standard for most early-stage venture capital.

Look for a Cap: If an investor insists on a participating preference, try to negotiate a participation cap. A cap limits the total amount the investor can receive. For example, a "2x cap" means the investor's total return from the deal (liquidation preference + participation) cannot exceed twice their initial investment. This limits the investor's double-dipping and protects the founder's upside.