One of the more material, contentious and potentially confusing issues in negotiating venture capital term sheets is the structure of the so-called liquidation preference. Perhaps better thought of as the “exit preference” this is the term that spells out how the proceeds from a sale of the business are divided between the common shareholders and the various investors holding shares of preferred stock. Since the vast majority of successful exits involve selling the company, the structure of the liquidation preference is a critical part of the investment terms.
There are two basic takes on liquidation preferences. One – preferred by investors – is called participating preferred. With participating preferred, when the business is sold the investors get their money back before any exit proceeds are distributed to the common shareholders. Next, over and above that “base preference” amount, the investors share the remaining proceeds pro rata with the common shareholders, assuming for such purposes that their preferred shares were converted into common shares the instant before the distribution to common shareholders. The other liquidation preference paradigm is simpler (and preferred by founders and other common shareholders, who generally characterize participating preferred as “double dipping”). With so-called “non-participating” preferred, the investors holding preferred shares have to make a choice. Either they can get their money back via their base reference OR they can convert to common and share the entire proceeds pro rata with the other common shareholders. With non-participating preferred investors can’t “double dip.”
Now, if you run the numbers, you will find (trust me on this) that while the difference between so-called “participating preferred” and “non-participating preferred” impacts who gets what in every case where the proceeds available for distribution exceed the amount of the preferred’s base preference, the relative impact – that is, the impact when considered in terms of how much money the preferred and common shareholders ultimately get relative to each other – gets smaller as the difference between the amount available for distribution after payment of the base preferred preference gets bigger. As a practical matter, if a deal is a “home run” (say 10x or more return on the preferred investment price) only the true bean counter of an entrepreneur is going to lose much sleep over the “extra” return delivered to the preferred investors on account of their enjoying full participation.
So, investors are better off with participating preferred, while founders are better of if the investors get non-participating preferred. And the differences in outcomes can be quite significant for both parties when the exit produce a modest win for the investors rather than a home run – which is to say in most positive exits. Not surprisingly, then, entrepreneurs and investors have looked for ways to compromise on the participating/non-participating term.
The most common compromise is capped participating preferred stock. With capped participating preferred the preferred has a choice but it is more complicated than the choice with non-participating preferred. Basically, with capped participating preferred the choice is between participating but only until the agreed cap on participation is reached OR foregoing the base preference and share all the proceeds available at the exit with common shareholders as if the preferred was converted to common immediately prior to the distribution. So, for example, with a 3x cap, the preferred would choose to participate if the alternative – immediate conversion – would result in less than 3x the basic participation preference. By way of a simple example, if the preferred held one million shares for which it paid $1 per share (and ignoring any complicating factors such as unpaid cumulated dividends that add to the basic preference) and enjoyed a 3x participation cap, it would choose to convert only if by doing so it would receive as its pro rate distribution more than $3 million.
On a quick read, capped participating preferred seems pretty straight forward. Unfortunately the simplicity of this particular compromise comes at a price: it obscures some nuances of liquidation preference participation return caps that at least somewhat undermine their appeal. The first, and most obvious flaw, is that return caps do not effectively reflect a compromise between the preferred and common shareholders over the range of deal returns – the modest positive exit – where the difference in outcomes most acutely impacts the common shareholders. As previously noted, the impact of participation on the relative returns of preferred and common shareholders is larger when the deal return multiple is lower, and rapidly decreases in significance as the deal return multiple increases. So unless the return cap is very low – say 2-3x max – most of the “double dipping” advantages to the investors associated with participating preferred will still exist.
The second flaw is far less obvious, and, is more or less important depending on how cynical the entrepreneur is about her investors.
Recall that with participating preferred an investor’s share of exit proceeds consists of his base liquidation preference plus pro rata participation in any remaining proceeds. In this scenario – in effect a 1x cap on the liquidation preference – the investor, during the negotiation of an exit transaction, will always have an incentive to seek the highest exit price because the investor will get a portion of every additional dollar of exit proceeds – every dollar up to her base preference amount and a pro rata share of every dollar above the base amount.
But now let’s consider an exit cap of, say, 3x. Assume also that the investor has a $1 million base liquidation preference, and that the investor and the entrepreneur each have a 50% share of the equity. Now let’s look at three exit scenarios: exit proceeds equal or less than $6 million; exit proceeds greater than $9 million; and exit proceeds between $3 million and up to $6 million.
In the first case, where the proceeds are less than or equal to $6 million, the investor will always take participation, as that choice will always deliver 50% or more of the proceeds to the investor; i.e. the investor will get at least his pro rata share (in fact at $6 million the investor will get exactly his pro rata share, $3 million, and at $6 million will get that $3 million plus his 50% pro rata share of the next $3 million, for a total of $4.5 million).
Now let’s assume the exit proceeds are greater than $9 million. The investor will always decline participation and convert, because his pro rata share of any amount over $9 million will always be more than $4.5 million – his pro rata share of the $9 million of exit proceeds.
Did you notice something here? In the case of $6 million of exit proceeds the investor will get $4.5 million by participating. In the case of $9 million of exit proceeds the investor will get $4.5 million whether he participates or simply takes his pro rata share. That leaves the case of exit proceeds between $6 million and $9 million, and if you run any number in that range you will see that the investor will prefer participation and in each case will end up with $4.5 million. Thus the investor will be indifferent between a deal that provides exit proceeds of anywhere between $6 million and $9 million because all of the proceeds between $6 million and $9 million would go to the entrepreneur. This “zone of indifference” means that in any exit negotiations the investor has no incentive to push the buyer to pay more than $6 million unless they think they can get the investor to pay more than $9 million. Indeed, once the investor perceives the company could fetch $6 million in an exit there will be some temptation to sell right away as the next 50% of value building will all accrue to the common shareholders.
How important, from the entrepreneur’s perspective, is the zone of indifference implicit in any participating preferred with a cap scenario? Well, that depends, as suggested earlier, on how big the likely zone of indifference is in the particular instance (a function of the size of the cap, the size of the base preference and the pro rata ownership of the investors), and how much faith the entrepreneur has that the investor will support an entrepreneur negotiating for a higher exit price when the likely higher price is still within the zone of indifference and thus all the benefits of the higher price accrue to the entrepreneur. Human nature being what it is …, well….?
And so, we end where we started. Yes, entrepreneurs and investors looking for a middle ground between participating and non-participating preferred stock can split the difference by settling on participation with a cap. But caveat emptor – or, more to the point, caveat entrepreneur. The benefits, to the entrepreneur, of the cap are not as appealing in practice as they are in theory.