In an earlier blog (Capping Preferred Participation: A Compromised Compromise) I argued that the usual middle ground between entrepreneur-friendly “non-participating” preferred stock and investor-friendly “participating” preferred stock – capping participation at some multiple of an investor’s base preference – is seriously flawed. Herewith an alternative approach.
By way of a quick refresh, we are talking about “participation” in the context of a preferred stock liquidation preference. In an exit transaction (other than an IPO) an investor holding “participating” preferred shares gets two bites at the exit proceeds apple. First, a bite equal to his base preference (typically an amount equal to his investment) and then a second bite equal to his pro-rata share of the remaining exit proceeds.
An example. An investor who put down $1 million for a 40% ownership position in Newco in the form of “participating” preferred shares would, in the event Newco was sold for $3 million, receive $1 million “off the top” and in addition 40% of the remaining $2 million of proceeds, for a total of $1.8 million. That means the investor, who owned 40% of Newco when it was sold, would get 60% of the exit proceeds. If, instead, the investor held “non-participating” preferred shares he would, in this example, receive either (at his option) (i) his $1 million base preference or (ii) his 40% pro-rata share of the $3 million, or $1.2 million. Clearly, the investor would take the $1.2 million pro-rata share. And leave the entrepreneur with $400,000 more money than he would have had if the investor had held participating preferred.
Looking at the above example, it is not hard to see why entrepreneurs don’t like participation and investors do: while the relative impact of the participation right diminishes as the exit proceeds rise (in the example, the difference is always $400,000), at every exit that leaves anything for the common shares, the investor with participating preferred gets more and the entrepreneur less.
In light of the above, entrepreneurs and investors long ago came up with a compromise on the participating/non-participating issue, the so-called “participation cap.” As with non-participating preferred, “capped” participating preferred gives an investor a choice. When exit proceeds are being distributed, the investor can choose to take either his pro-rata share of the proceeds (his percentage ownership at the exit) or his base preference plus participation in the distribution of the remaining proceeds until he has received in the aggregate an amount up to some multiple – say 2x, or 3x, etc. – of his base preference.
Now at first glance, capped participation seems like a reasonable compromise on the participation/non-participation negotiation. As my earlier blog pointed out, however, it is a compromised compromise. The problem – if you don’t want to go back and review the prior blog, just trust me on this – is that when you cap the participation preference you create a situation where there is range of exit proceeds (a “zone of indifference”) where an investor doesn’t care what the exit proceeds are. In the example in the earlier blog the investor got the same payout ($4.5 million) for exit proceeds anywhere between $6 million and $9 million. Faced with a deal that promised $6 million in exit proceeds, the investor would have no incentive to negotiate for a higher price unless he thought he could get the price up at least to $9 million plus one dollar – in which case the investor would get a fraction of that final dollar. A savvy entrepreneur should, it seems to me, be skeptical of an arrangement where an investor was indifferent over how much money the company was sold for over a significant range of plausible exit scenarios.
Fortunately, there is a better compromise, to wit “partial participation.” In this compromise, the entrepreneur and investor agree that the investor’s “second bite” at the proceeds apple will be some fraction of the investor’s pro-rata ownership share. So, for example, that fraction might be one-half. Going back to our initial example where the investor has invested $1.0 million for a 40% ownership interest, and the exit proceeds amounted to $3 million, the investor would first get his base preference ($1 million) and then get an additional $400,000 (one-half of 40% of the remaining proceeds). The “second bite” would be worth exactly one-half of what it would be worth if the investor had full participation. If the partial participation fraction was set at one-quarter, the “second bite” would be worth exactly one-quarter what it would be worth compared to full participation, and so on.
Compared to capped participation, partial participation is much easier to understand – the compromise consists of picking a fraction between 0 and 1, which such fraction perfectly represents the way the compromise plays out as a fraction of full participation. But even more important, partial participation has another big advantage over capped participation: there is no zone of indifference. There is no range of exit prices where the investor is anything less than fully incented to work with the entrepreneur to negotiate a better price. And that, for me, makes partial participation a better participation compromise.