When it comes to startup financing, the concept of the preference stack is often misunderstood. Many founders believe equity is equity, that all shareholders are treated equally when an exit occurs. But the reality is far more nuanced. Venture capital (VC) preferred stock, in particular, behaves much closer to debt than most realise.
How the Preference Stack Works
If your company raises $1M in venture capital funding, that money doesn’t simply blend into the equity pool. In an exit, whether through acquisition, merger, or liquidation, investors have a contractual right to get their $1M back first, before common shareholders such as founders, employees, and early supporters see any return.
This arrangement is known as a liquidation preference. A common structure is the 1x non-participating liquidation preference, which means that VCs get back their original investment ($1M in this case) before common equity holders receive anything.
Once that amount is returned, any additional value created in the exit is shared among the remaining shareholders, with common equity holders participating in the upside.
VC Preferred Stock vs. Debt
At a structural level, preferred equity looks surprisingly similar to debt.
- Downside Protection: Just like senior debt, venture capital investors minimise their risk by guaranteeing repayment first.
- Exit Priority: Both senior debt holders and preferred equity investors sit at the top of the payout waterfall, ahead of common shareholders.
- Return Asymmetry: Unlike debt, preferred equity can also benefit from upside if the company grows significantly through conversion into common shares.
In both cases, common shareholders (often the founders and employees who built the company) are at the bottom of the stack.
Why This Matters for Founders
Understanding the preference stack is critical when negotiating funding terms. The difference between common equity and preferred equity determines who gets rewarded, and when.
The key takeaway? Always approach fundraising with a clear understanding of specific terms to avoid unpleasant surprises at the time of exit.
Preferred equity isn’t just equity, it behaves much closer to debt.
At Mighty Partners, we help businesses cut through the complexity of financing with flexible growth credit solutions.
If you have questions or want to learn more about how debt structuring works, reach out to us.
