The vast majority of term sheets will include a liquidation preference for the Preferred Stock - basically ensuring that the investors are paid out first if the company dissolves or is liquidated through a merger or acquisition. Nearly all venture financings have a liquidation preference, but there will often be negotiation around the details of how the preference works.
Recap: What are Preference Multiples?
In some cases, the liquidation preference may be great than 1x - sometimes 2x or 3x. This is referred to as a preference multiple. In this case, in the event of a sale or liquidation of the company, the investor will first receive 2x or 3x its initial investment before the remaining funds are distributed.
What is Participating Preferred Stock?
In some transactions, after the Preferred Stock receives their initial liquidation preference (1x, 2x, 3x or more), then they also receive the right to receive a portion of the remaining proceeds. Enter the concept of participating Preferred Stock. In the event of liquidation such as a sale of the company, the liquidation preference ensures that the Preferred Stock is paid back first (or paid back 2x/3x). But (and here's the kicker) participating Preferred Stock are then entitled to share (participate) with the common stockholders in the remainder of the proceeds.
Case Study: How Participating Preferred Stock Works
This time, Company A gets an outstanding offer to sell the company for $20 million just a year after receiving funding. The investors hold participating Preferred Stock. This means that the investors will first receive their $6 million back, leaving $14 million to be allocated. Now, the Preferred will participate based on their ownership (here 50/50) in the remaining amount -- $7 million going to each. So the investors receive $13 million and the founders receive $7 million of the $20 million purchase price. If the investors had held non-participating Preferred Stock, then the investors would have a choice: (a) exercise the liquidation preference and receive only $6 million, or (b) convert the Preferred Stock into Common Stock and take their portion ($10 million).
Why is Participating Preferred Stock important?
The difference between using participating and non-participating Preferred Stock in the term sheet was $3 million for the investors ($14 million vs. $10 million, and the reason that understanding a liquidation preference matters.
So hopefully you can now see why participation rights are a major negotiating point in venture financings. A non-participating preferred effectively requires that the preferred shareholders elect whether to retain their preferred stock and receive only their purchase price, or convert their preferred stock to common stock to share in the proceeds remaining after payment is made to any non-converted preferred stock. Participating Preferred shareholders receive their original purchase price and then participate with the common shareholders in the distribution of the balance of the remaining proceeds.