This series of legal guides has looked at the general conditions of a liquidation preference, preference multiples, and participating preferred stock. The final guide on the topic of liquidation preference will look at Capped Participating Preferred Stock and why it matters in your term sheet.
1
Recap: What is a Liquidation Preference?
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.
2
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.
3
Recap: 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.
4
What is Capped Participating Preferred Stock?
Based on the prior examples from the guides of preference multiples and participating preferred stock, it may seem that these terms are unfair. That’s not exactly the case. Historically, most venture deals involved a non-participating preferred stock. In recent years, however, many investors have insisted on a participating preferred to avoid the situation wherein the company is acquired for approximately the post-financing valuation (i.e., there is no appreciation in the value of the company) and (1) the preferred shareholders receive their invested amount but no return, and (2) the common shareholders receive a substantial return based on their lower cost basis. In negotiating this point, the company would argue that the investors should not expect a return if the company does not appreciate in value and that the investors should not be paid on the front end (the initial preference payment) and the back end (the distribution of the remaining proceeds) if the company is successful.
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Growth of Capped Participating Preferred Stock
As a result, use of capped participating Preferred has become much more common. With capped participating Preferred, the preferred stock will be participating in mergers where the return to the preferred shareholders would be less than a fixed multiple of the purchase price (typically between three and five times) on a straight pro rata sharing, and non-participating in mergers above that price point.
Capped participating Preferred is meant to reward everyone equally when the company has a very successful sale or merger event. At an acquisition above the “cap” price, investors would convert their Preferred Stock into Common Stock and share the distributed assets pro rata with all other holders. But, if the event is a medium success, the investors will receive a greater portion of the proceeds.
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