The names are made up. The math is real.1
Part One: The Founders’ Side
Marcus, Jim, and Sasha started Clarion in 2014 in a Tampa co-working space with a whiteboard, a shared Dropbox folder, and a disagreement about equity that they resolved the way most founders do… quickly and without a lawyer.
Marcus got three parts. He’d had the idea, and he had the contacts. Jim got two. He was the one who could actually build it. Sasha got one. She handled everything else, which meant she handled everything.
Six pieces total.
They were good at what they did. Within two years, they had paying customers, real ones; enterprise contracts, renewals, expansion revenue. By 2016, they had raised a friends round to get off the ground, then a proper Seed, then a Series A when the metrics started singing. By 2018, they had closed a Series B, moved into a real office, hired fifty people, and were doing ten million dollars in annual recurring revenue. Their investor deck called them the category leader. For a moment, they believed it.
Then COVID arrived and rewired the world.
The customers didn’t churn immediately, enterprise never does, but the pipeline froze. The Series C conversations that had been warming up went cold. The board grew nervous. Cash got conservative overnight, runway suddenly mattered, and the board’s tone shifted from “build the category” to “don’t die on principle”, especially with a preference stack that needed an exit to get repaid. A strategic acquirer materialized with an offer of $30 million dollars. The founders looked at each other across a Zoom call, exhausted and uncertain, and they took it.
They announced the acquisition to the company on a Friday afternoon. They thanked everyone for their sacrifice and their belief. They said the shares had been valuable once, and would have been valuable again, but that the structure of the deal was what it was.
The employees, some of whom had taken below-market salaries for years on the promise of equity upside, received checks that ranged from a few thousand dollars to nothing.
Marcus, Jim, and Sasha told everyone, honestly, that they had made nothing either.
Several employees never forgave them.
Part Two: The Employees’ Side
Nobody reads a cap table at an offer signing. That’s not cynicism, it’s just how it works. You’re excited. The mission is real. The option grant has a number in it that sounds large. The recruiter says the last round valued the company at eighty million dollars.
What nobody explains is that your options are common stock. That they sit at the bottom of a waterfall. That every round of funding above you is preferred stock with a liquidation preference, meaning those investors get their money back, in full, before you see a cent.
Here’s the math that was never shown to Clarion’s employees.
By the time of the Series B, the company had raised approximately $26 million dollars across four rounds. Each round came with a 1x liquidation preference, standard language, nothing exotic. That means investors get their $26 million dollars back before the distribution waterfall reaches common shareholders.
The exit price was $30 million dollars.
After the $26 million in liquidation preferences, after legal and banking fees of roughly one to two million, after the transaction costs of closing an M&A deal, there was somewhere between two and three million dollars left to be distributed among every common shareholder, founders included.
Sasha’s one part of six, diluted through four funding rounds and the option pools required to hire those fifty people, might have represented two or three percent of common stock by the time the deal closed. Two percent of $2 million dollars is $40,000 dollars. Before taxes.
Jim built the product. He got more, but not dramatically more.
The employees with options, most of whom had strike prices set at 409A valuations from earlier, higher-valuation periods, received distributions that in many cases didn’t clear the cost of exercising. Some received nothing at all.
And this is the part outsiders miss… in a down exit, an option holder can be underwater. You’re not just “not getting paid.” You’re being asked to write a check to exercise shares that are worth less than the exercise cost, so the rational move is to walk away, and it feels like your compensation evaporated retroactively.
They had been told their equity was worth something. At the $80 million dollar Series B valuation, it was, on paper, in a world where the company continues to grow and exits above that number. That world didn’t arrive. What arrived instead was a down exit into a preference stack that had been quietly stacking for four years.
Nobody lied to them. But nobody showed them the waterfall either.
The Structural Reality
This is not a story about bad founders or predatory investors. Most of the participants in the Clarion story acted in good faith. The problem is architectural.
Venture capital math depends on a portfolio model. Most companies fail. A few return the fund. The liquidation preference exists to protect investors in the vast majority of outcomes that don’t produce spectacular returns; the acqui-hires, the down exits, the modest outcomes. From the investor’s perspective, it’s rational insurance.
The problem is that the employees of those companies, the ones hired with equity as a core part of their compensation, are carrying risk with no corresponding protection. They are common shareholders without the secondary market access, the portfolio diversification, or the information asymmetry that investors hold. They are, in the language of capital structure, subordinated in every direction.
When the exit price clears the preference stack with significant room to spare, this doesn’t matter much. When it doesn’t, the waterfall is a cliff.
How It Could Be Different
The mechanisms to fix this already exist. They’re just not standard. Here’s what a more equitable startup ecosystem looks like.
Capped liquidation preferences. Non-participating preferred forces a choice: either take the 1x preference or convert to common and share pro-rata, no double-dip, rather than continuing to participate in remaining proceeds alongside common shareholders.
This was more common two decades ago and has been quietly disappearing.
Some investors still insist on participating preferred, which is effectively “double-dipping”… they get their 1x back first and then they also share pro-rata in what’s left. Banning participating preferred from term sheets wouldn’t eliminate the waterfall problem, but it would shorten the drop.
Pro Tip: Participating Preferred
If preferred is participating, it gets paid twice: once at the top of the waterfall (the preference), and again alongside common (the participation). It’s legal. It’s common. It’s rarely explained.
Employee secondary liquidity windows. Every significant funding round should include a formal mechanism for employees to sell a portion of their vested shares, the same way founders routinely do in secondary transactions. This is gaining traction at some of the more thoughtful funds, but it remains opt-in rather than standard. If employees can convert some equity to cash during the company’s growth phase, they are not entirely dependent on a terminal exit event to see value.
Full cap table disclosure at offer. When a company makes an equity offer to an employee, that offer letter should include the full capitalization table with all preference terms. Not a summary. The actual terms.
An employee accepting equity compensation is taking on investment risk; they should have the information that any rational investor would demand before doing so. This doesn’t require legislation, it requires companies that treat their people as partners rather than resource inputs.
Proceeds participation rights. Some companies have negotiated contractual floors that guarantee employees a minimum percentage of exit proceeds regardless of the preference stack. This requires investor agreement and board approval, which means it requires investors who are willing to accept it. They exist. The terms can be written. It simply isn’t done because it isn’t required.
Plain-language equity education. This one is the cheapest and most underused. A one-page document that explains, in plain language, how liquidation preferences work, what a down exit looks like numerically, and how to read a cap table. This should be part of every onboarding package at every startup that grants equity. The asymmetry of information in these situations is not accidental, but it can be corrected voluntarily.
The Harder Question
The Clarion employees were not naive. They were engineers and designers and account managers who believed in what they were building and accepted lower salaries because the equity story made sense. The story did make sense at the valuation where the equity was granted.
What changed wasn’t their contribution. What changed was the exit multiple, the timing, and the preference stack that had been accumulating in the background through every round they helped make possible.
The system, as designed, transferred risk downward without transferring information downward to match it. The people who bore the most outcome risk with the least information protection were the ones who showed up every day and built the thing.
That’s not a law of nature. It’s a convention. Conventions can be changed by people who decide to change them, by founders who design their cap structures differently from the start, by investors who compete on terms as well as check size, and by employees who ask to see the waterfall before they agree to stand at the bottom of it.
And as a bonus at the end of this 3 part series, an app for everyone to use to remove the complexity.
- Next: The Option Pool Shuffle: Every funding round quietly takes something from you before the money arrives.