BLOG STARTUPS, VENTURE AND THE TECH BUSINESS
The View From The Dark Side #2: Participating Preferred
Entrepreneurs often dislike participating preferred stock. It can be a contentious term at investment time, and I often sense resentment at exit time when investors “get $XX million off the top”.
“Participating preferred” refers to convertible preferred stock with a special liquidation right: preferred stock holders receive return of their investment, and then they share in the remaining proceeds with other stockholders on the basis of as-converted ownership. The following chart illustrates how it works for a company where investors own 40% of common-stock equivalents in the form of participating preferred.
Does this make sense? Like most things in venture capital, there are some good and bad reasons for participating preferred.
Bad Reasons
The familiar refrain is: “that’s non-negotiable”, “that’s the way we always do things”, or “my partners would not consider any other option”. We’ve all had crummy terms forced on us. Venture investors should realize that they are entering into a partnership with entrepreneurs: there will be lots of give and take over a long period of time, and what goes around might come around. We need to strike deals that make sense to all key parties.
Better Reasons
The argument “it’s a standard term” makes more sense to me. Convertible Preferred is definitely standard; participation is common (more so on the East Coast than the West). “Standard” implies the term is widely used, experience shows it works well, and negotiators on both sides have gotten comfortable with it. And, related to that, the A round investor knows that later round investors will ask for this term: if s/he does not get it and the later rounds do, the Series A investor is at a bigger disadvantage to later series than is usual.
Best Reasons
For Series A rounds in capital efficient companies (where we usually play), Participating Preferred can produce a good alignment of interests. Here’s how. Let’s assume that a VC invests using non-participating convertible preferred at $10 million post-money value, and the founders own most of the company. If an exit opportunity comes along at $20m, that can be very attractive for the founders: they split up $12-$16 million, which is good money for a couple of years of work. The VC, however, gets about a 2x on a smaller-than-expected investment, which does little for the success of the fund. If the VC’s preferred is participating, however, the VC would get 3x, and the founders would split up a bit less: $10-$14 million. That’s a more balanced outcome if it happens, and it gives the founders more incentive to strike for the bigger win that was envisioned when the VC invested. One of my CEOs, who accepted a term sheet with participating preferred, told me his board and he understood it in these terms.
“Follow the money” (Deep Throat’s mantra in All the President’s Men) is usually good advice. If you follow the money in venture-backed companies, you find something that’s not always recognized.
Investors pay in most of the money, by definition. There may be some additional non-dilutive money from government, etc. Here is where the money goes:
1) Most of the money that comes in from investors goes out to employees in the form of salary and benefits: typically about 75%. So, if you follow the money, the first payment goes to the employees. At this point the VCs and other investors have gotten zero.
2) When the exit comes, employees almost always get a minimum 10% of the proceeds, whether or not the exit is profitable. To check this I looked at three recent unprofitable exits in our portfolio: exits that returned 8%, 20%, and 55% of invested capital. In every case employees got 10%-15% of proceeds, regardless of the cap table: in two cases the payments were promised as stay bonuses to incent employees to work to an exit; in the third case the board decided to pay out 10% to employees as a matter of fairness. Since it always happens, this 10% payment to employees is effectively off-the-top. So employees get the second payment, too.
3) In a participating preferred stock structure, investors get their cost back next: the third payment goes to investors. This assumes of course that there has been no recap that cut liquidation preferences along the way. Recaps have been frequent of late – if a company struggles for years, raises a lot of money, and eventually has a fair exit, employees present at the exit typically get 15%+, and early investors get dimes on a dollar.
4) Investors and employees share what is left. The fourth payment is split on the basis of as-converted ownership. If the company does well (4x or better invested capital), the fourth payment dominates the others, and employees receive a share of proceeds close to their ownership of common share equivalents (see chart above for an example).
5) If the preferred stock is non-participating, then investors have to choose between the third payment and a share of the fourth.
Everything needs to make sense in the specific circumstances, of course. Through this lens, however, participating preferred often looks fair to me.
