Preference Vs Participating Preferred Stock

Entrepreneurs often see headlines about multi million dollar IPOs, Mergers and Acquisitions, and think the the founders must have made a killing. While in many cases this is true, it’s not always the case, and often some founders may be shocked by realising that what they think they own isnt really the same as what they actually own.

One of the reasons for this lies in the different types of stock that are created when founder take VC funding.

There is a ‘pecking order’ so to speak of stock. Below is a breakdown of the different types of stock.

Ordinary Common Stock

This is normally the the type of stock that founders hold. In terms of the pecking order of things this stock is right at the bottom of the pile.

However, when an IPO occurs, all of the Preferred (or Preference Shares — see below) share are converted into Common shares, which are then sold/floated onto the public market.

Preference Shares

Preference shares have a fixed, capped participation from distributions from the venture. Thus they are similar in some respects to debt instruments. The participation may come in the form of dividends or through the liquidation.

They are a way to protect the VC fund from the potential downside, while fixing their potential return on the investment.

Oddly, the preference share doesn’t have any upside potential in and of itself (the upside value comes in the form of its convertibility, meaning it can be converted to Common Stock).

There will be a point as the venture approaches liquidation where the value of the Converted Preference stock will be greater than the value of the Preference stock itself. At that point it most VCs would elect to convert their Preference Shares and participate parri passou, pro rata with the rest of the investors.

Thus the return for the VC is the greater of either:

a) The value of the Preference Stock OR

b) The value of the Common Stock that the Preference Shares can be converted into.

Preferred Participating Stock

This is a type of stock has the same type of downside protection as Preference Shares, normally with a certain premium in the form of a dividend, or a ‘liquidation preference’. After this has been recouped then the VC is ALSO able to share in the proceeds from the sale of the common stock on a parri passou pro rata basis. As such there is no need to convert Preferred Participating stock, as it has upside potential inherently built into the structure.

A liquidation preference is a the ‘multiplier’ of the original investment that the Preference share holder is entitled to on liquidation.

So, take an example:

Investor A funds a startup with $1m in Seed funding, which is for preference stock held with a 2x liquidation preference.

This means that the Investor is entitled to 2x their original investment before any of the other shareholders are able to partake in the proceeds from a liquidation event.

If you firm IPOs at $2m — all of this money will go to the Investor — so you will need to IPO for over this value so that you might share in the proceeds.

Also beware that Investor A will also want to participate in the rest of the IPO, pro rated with their ownership of the firm.

So, if Investor A owns 40% of the equity in the firm, then they will take 40% of any proceeds above $2m as well.

That means that if you exit at $3m, then Investor A gets:

$2m from their Liquidation Preference — leaving $1m to be shared among the other investors.

$400,000 from the remaining $1m for their 40% ownership of the firm.

That leaves only $600,000 for the founders, from a $3m exit.

So VC just screw Founders?

This may look as though the VC is screwing the Founder, particularly from the Founder’s point of view, as its her hard work that has brought about the IPO in the first place.

However, as a VC, I would say you need to remember whose taking the risk? The VC firm has injected $2m in cash into something that may be an unproven technology or idea. Even if proven, there is still risk in execution, market timing, economic shift, technological obsolescence and on and on.

The liquidation preference is a means for the VC to try and protect their investment by making sure that they are paid out first.

Assume that the IPO only happens at $1m. In that case Investor A will take all the $1m, but he’s still out $1m. The founders will get nothing, except their salaries, the experience of taking a firm public, and the credibility that this experience brings with it for future ventures.

The VC just loses $1m.

Incentives

Another way of thinking about the liquidation preference is as an incentive stick to drive management to hit their numbers and ensure the highest possible valuation for the Investors, which seems fair, considering the risk that they’re taking.