Venture Capital Term Sheet: Liquidation Preference (PART 4: Capped Participating Preferred Stock)
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.
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.
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.
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.
Growth of Capped Participating Preferred StockAs 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.
Case Study: How Capped Participating Preferred Stock WorksAgain, Company A gets an outstanding offer after the first year to sell the company for $20 million. As before, the investors hold participating Preferred Stock with a 1x preference multiple, but this time there is a cap set at 4 times the original purchase price (often this also includes dividends, but we'll skip that here). So, if the management decided to take this deal, the investors would get $13 million ($6 million from the 1x liquidation preference and then 50% of the remaining $14 million) and the founders would get $7 million (their half of the $14 million after the initial $6 million to the investors). While this would be a nice result, management believes there is more to the company and rejects the merger.
Case Study: How Capped Participating Preferred Stock Works (FAST FORWARD 2 YEARS)Fast-forward to two years later. The company has taken off like a rocket and now receives an offer from a new suitor to purchase the company for $60 million. Because of the cap, the investors now have a choice. They can (a) take $24 million which is 4x their original purchase price and no more, or (b) convert their stock into common and receive $30 million, half of the total proceeds from the sale. Without the cap, the investors would receive $33 million ($6 million from the 1x liquidation preference and then 50% of whatever remains) and the founders $27 million (their half of the $54 remaining after the $6 million from the liquidation preference). Use of the capped participating Preferred may provide for better alignment of priority among the investors and founders.
How likely is participating Preferred and what are typical caps on participating Preferred Stock?Only 50% of Series A financings have participating preferred. Of those 50%, half (25% of the total) have uncapped participation rights while the other half (25% of the total) have caps at various levels.
No participation beyond 1x liquidation preference Series A 50% Series B 41%
1x -- 2x Series A 7% Series B 10%
2x -- 3x Series A 13% Series B 13%
Greater than 3x Series A 5% Series B4%
Uncapped (full participation) Series A 25% Series B 32%
Source: Private Company Financing Report, Cooley Godward Kronish LLP, November 2007 (based on financing transactions in the 2nd quarter of 2007)
Additional resources provided by the author
- My High Tech Startup
- Starting a High-Tech Business Venture
- Venture Capital Term Sheet: Liquidation Preference (PART 1: General)
- Venture Capital Term Sheet: Liquidation Preference (PART 2: Preference Multiples)
- Venture Capital Term Sheet: Liquidation Preference (PART 3: Participating Preferred Stock)