When there is a 95% chance you make nothing: how preference stacks work in startups

The un-examined psychological challenges of the preference stack (and what to do about it.)

6 Jul 2024 — 9 min read

When there is a 95% chance you make nothing

A not so fun phone call

I remember where I was sitting in my office. I was on the phone with one of my advisers halfway through the journey of my last company. I began the call feeling optimistic. We had grown revenue 5x in the prior year while keeping headcount low to support the company’s path toward profitability. A year prior, we had navigated a substantial layoff following a slump in the venture capital markets. I was proud of the progress we had made. Despite a few bumps in the road, I was optimistic about our path ahead as we aimed to position the company for sale or growth equity in the coming year.

My trusted advisor was not so optimistic.

After listening patiently to my summary of the prior quarter, he pointed out several risks that persisted in our growth strategy. He probed at our churn and compared it to SAAS companies finding desirable multiples in the M&A markets. We did not stack up.

I explained our plan for surpassing $10M in ARR in the coming months without adding to our costs, a milestone that had seemed impossible 12 months prior when we were all but dead in the water. My advisor replied:

Even if you can get there, I’m not sure you sell for more than the preference stack. Which means you still make nothing.

My chest tightened, my shoulders slumped, and I felt crestfallen. This was not the feedback I expected on the call.

For those who may be unfamiliar, here is how a preference stack typically works. When a company raises outside capital, that capital typically comes as preferred shares. By contrast, founders and early employees hold common shares (or options). Preferred shares have several privileges, including the right to be paid back before common shares. If a company raises debt, the debt holders are paid before preferred shareholders.

For example, if a company raises $20M in equity and $5M in debt, the preference stack would be:

$5M debt
$20M preferred

= $25M preference stack

Typically, that entire $25M must be paid back before common shareholders see a dime.

I could not believe the weaknesses my advisor was pointing out might leave our prospective sale price below our stack. How was I still here after so much work?

The financial mechanics were not news to me (although they are to many first-time founders I meet), but the idea that we could have come so far and still be in a place where we would make nothing; that was gut-wrenching.

How we got there

When my friends and I decided to start a company together, we wanted to be founders more than anything. It was not about getting rich; it was not even about changing the world. It was about working on something we cared about with people we loved. And it was about avoiding the need to get jobs.

We did not thoughtfully weigh the tradeoffs of bootstrapping our business or raising outside capital. Because our main goal was to be founders, we leaned into getting money to fund the business any way we could.

In the early days, we consulted in the morning and built products in the afternoon. The idea of taking money from professional investors, should they offer it to us, seemed obvious.

By the time we were raising real money, millions of dollars, from brand-name investors, it seemed like an even more obvious choice.

Should we take more money than we thought we were raising? Of course!

Should we take a valuation 3x higher than we thought we deserved? Why not!

Raising money felt like a secure path to ensuring we would never run out of money and never have to get jobs.

Raising a LOT of money felt like a guarantee we would get rich.

After all, on paper, we already were rich. We were all multi-millionaires. And these were some of the smartest investors on the planet. If they thought our company was worth tens of millions of dollars and were willing to say so on a term sheet, they must be right. At least in the ballpark?

Most of you grizzled founders reading this will be chuckling at what an idiot I was to think this way. And you are right. At least, my thinking was idiocy. That is not how it works.

The VCs were doing their jobs. I do not fault them in the least. VC deals are not structured to make founders rich first and foremost. They are structured to get investors into the deals they want to get into. They are structured to provide capital to companies needing capital to grow. And they are structured to protect as much of the investor’s money as possible when things go sideways.

That last piece is where things get sticky for founders.

The exact reported numbers are mixed, but only about:

0.2% of companies that seek venture capital receive it.
Of those who receive venture capital, 75% fail to return that capital.

That means even when we beat out 99% of companies to gain funding, built a million-dollar revenue business, and convinced several top-tier investors to fund us, we still had a 75% chance of not making a dime off our work.

I failed to appreciate as the company scaled fully how hard it would be to evolve a high-risk, fast-growth business to a mature, de-risked company worthy of acquisition. While the tech press is full of stories about early-stage companies snapped up for massive valuations, this is not the norm.

To get acquired, most companies have to build a real business. They need:

Years of sustained growth
Multiple proven acquisition channels
Multiple proven revenue channels
And a clear story of how the future is even rosier than the present

As my call with my advisor revealed, despite our tremendous success and years of hard work, we did not yet have that—and we would not for some time.

The strain on founders

As a founder turned coach, I am surprised how rarely the challenges of this setup are talked about in the startup community.

Investing years of your life into building a business without knowing whether you will make a dime off it is a sizable ask.

It’s one thing to face the challenges of building something from nothing and wondering whether you have what it takes to build something the world wants. That is the gamble we founders are signing up for.

The greater and lower-percentage endeavor I believe many first-time venture-backed founders fail to fully appreciate they are signing up for is that of rocketship or bust.

And not just rocketship, but sustained rocketship over time.

Time + momentum + defensible massive market = the recipe for a successful startup outcome.

If you miss any of these items, you are unlikely to survive the fate of becoming a zombie company. And zombies do not beat their preference stacks.

It is very hard to maintain momentum over time. Most companies flatten out at some point. And if you, as a founder, have failed to take any money off the table before things slow down, you may have difficulty doing so later.

And it is not only the financial outcome that can feel binary and delayed; the emotional outcome can feel equally daunting. As a coach, one of the biggest fears I hear from founders years into building a successful startups is:

What do I do if this fails?

How would I start another company if I make zero money?

Am I even employable anymore if I need to get a job?

Of course, our fear-states often catastrophize these scenarios in our heads. I would wager that no founders talented enough to start venture-backed companies will go hungry because of a lack of meaningful work. But these fears are widespread for a reason. It can feel like no matter how much we achieve as our businesses scale, we have proven nothing until we exit or go public. This is a deeply shared internal experience among venture-backed founders. I know it was true for me.

Thus, in addition to a prospective financial outcome, it often feels like our status among friends and colleagues, future earning potential, or employability is on the line. In the hardest moments of company building, when what we most need is a sense of equanimity so we can tap into our deepest resources of creativity and problem-solving, this can be a lot to carry.

So what are we as founders to do?

Let’s explore some practical steps for navigating these financial and emotional challenges.

Practice steps

Here are five practical steps for navigating this uniquely challenging part of building a venture-backed business. (Note: This is not meant to be an exhaustive list, and if you would like some partnership in exploring the particularities of your own situation, please reach out.)

Build a real business not a valuation engine.

It is easy to get caught in the hype of building a company that has a high valuation on paper. After building in isolation for months or years, it can feel deeply validating for a professional investor to tell you your company is worth millions of dollars.

Don’t take the bait.

Use valuation negotiation to your company’s benefit to properly capitalize the business. But do not get trapped into chasing valuation for valuation's sake.

The higher the valuation of your prior round, the further the goalpost for an exit or future rounds of funding.

It doesn’t matter whether you are worth $1M or $50M on paper unless that paper turns into cash.

Keep your eye on the goal of building a real business. You do not have to be revenue-obsessed in year one but do not lose sight of building a business eventually generate profits. Capital markets go up and down, but growing, profitable businesses never go out of fashion.

Deeply understand what de-risks your business for M&A and further financing.

I shared above I made the mistake of waiting too long to understand how prospective acquirers would assess the risks of my business. As we approached the $10M ARR mark with solid growth, we assumed we would dictate our own destiny. However, my advisor was correct in honing in on our churn as a major issue for many prospective acquirers.

Don’t make the same mistake I did.

Explore early how businesses like yours are assessed. Take off your rose-colored founder glasses and learn to look at your businesses the way a dispassionate investor might. It’s OK that there are weaknesses; it's better to know them now so you can work on them over time.

Explore secondary rounds.

Repeat after me: I promise to take some money off the table whenever possible.

Now, repeat it once more.

I get it. You think your business is the hottest thing going, and you are turning down term sheets like crazy. (Note: If that’s not the case, fret not. This is not the case for most of us. That’s ok.)

But when you can create some personal financial runway for yourself, please consider taking it.

Most smart investors will support this in a decent market because they know within reason it aligns you with their interests. You get a little padding in your savings account so you can think big and go long; that is exactly what they want you to do. Some mediocre investors will cringe at this, saying, “We only want founders who are all in on their businesses.” Rubbish. your Reasonable investors will understand your request to take a handful of percentage points off the table when possible. Do not feel ashamed to explore this option.

If you cannot right now, that is okay. Write this advice down for later and re-read it when you hit that growth round.

Re-negotiate where needed to align incentives.

Many founders I meet have twisted cap tables, salaries, or other structural issues that leave them stressed out and misaligned with their investors.

When I meet them, they often feel a sense of shame about the situation.

There is no need to be ashamed.

Startups are very strange rides. And all kinds of crazy stuff happens along the way.

It is the board’s job to ensure the CEO and executive team have aligned incentives with shareholders. If you sense you may not, bring the concern to the board—or to your in-house counsel first and then the board. You do not have to have the solution in hand. It may be an opportunity for deeper partnership with those around the table.

If you would like some help exploring this topic, please reach out.

Seek help to ensure you deeply understand your financial picture and options.

Lastly, make sure you understand your personal financial picture and that of the business.

Work with your legal counsel and a financial advisor to inform your understanding. When making significant decisions about capitalizing the business or your own compensation, request the materials you need to make an informed decision.

Many of us founder types have grown up as caretakers of others and have difficulty prioritizing our own well-being.

In funding rounds, for example, you are responsible for caring for the business, the shareholders, the employees, and the customers. But you also have another hat to wear: the hat of your own self-interest. It is okay to watch out for your own needs as well.

Request the materials you need to understand your personal tradeoffs. These might include: