Let’s begin with the basics — capitalisation tables (a.k.a cap tables) track ownership in the company’s share capital. They aren’t just used to track percentage holdings, they reflect share classes. Employees and founders typically hold common shares; investors typically get preferred shares. Cap tables also reflect how the proceeds of an exit (called a “liquidation event” in the term sheet) are divided between shareholders, according to their share classes.
What’s often missed is the tie between the financing terms and the composition of the cap table. The reason is that the terms requested by new investors coming into the company — mainly investor-favorable terms, such as liquidation preferences — will depend on the terms received by the company’s earlier investors. This means that the term sheet a company agrees with its investors in the early rounds is then carried forward to subsequent rounds. (For general information about cap table terminology take a look at my cap tables 101 post.)
As the company moves from round to round, the cap table is used to simulate scenarios given holders of various types and sizes of securities. While the cap table may seem like a simple, technical document, it is a foundational component in the growth and evolution of a successful company. Knowing, understanding and managing a cap table is critical to help founders determine, negotiate and track ownership stakes as the company grows. If it isn’t properly managed, the result can be a cap table that creates misaligned interests with a cascade of liquidation preferences that create a participation overhang that hurts both the holders of common stock and potential future investors. As I suggested in my previous post, every line in the cap table matters, both in terms of the value the company receives from an investor and in terms of the negative impact caused by the terms associated with an investor.
This is why cap tables shouldn’t be viewed as a mere log of holdings. Rather, they should be used as a tool to understand how investment terms impact the next funding round, and the next, and the next.
Common vs. Preferred
Common shares have the most basic set of rights, privileges and preferences. Common shares are generally held by founders, employees and some angel investors. Preferred shares also represent an equity ownership position in a company, yet they convey a series of additional rights that are “in preference” over those of common shares, making the shares more valuable. One of the key rights that come with preferred shares is the liquidation preference, meaning that the preferred shares will have priority over common shares in a liquidation event, which in VC speak isn’t necessarily a bankruptcy or liquidation but also a sale, merger or change of control — an “exit”, in short.
Preferences are set with regards to other share classes, so essentially liquidation preferences are about which share classes get what in advance of other classes of shares. The preference is first paid to a certain class, let’s say the Series C Preferred shares. Only then are the remaining assets (i.e. the consideration of the exit) distributed among the other share classes. Except the price — valuation and investment amount — liquidation preferences are the most important deal term, since they set the rules for who gets what portion of the pie in a liquidity event.
- The liquidation preference determines what multiple of the original investment per share is returned to the investor before proceeds can be distributed to the holders of common stock. Let’s call this “Distribution Phase One”.
- Participation determines whether the preferred shareholders participate in the division of the proceeds with the holders of common stock after “Distribution Phase One”. In this case, which we will call “Distribution Phase Two”, fully participating holders will share the remaining proceeds (post “Distribution Phase One”) with common stockholders. Non-participating holders won’t.
Participating Preferred vs. Non-Participating Preferred
In a liquidation event, participating-preferred shares first get their full investment (oftentimes plus interest) and then their pro-rata share of ownership, together with the other shareholders.
Non-participating preferred shares, on the other hand, give the holder the right to collect the higher of (i) the amount invested in the company (sometimes this amount receives an annual interest) or (ii) a pro-rata share in the liquidation amount.
Let’s use a simple example:
An investor makes a $ 6m Series A investment at a $6m pre-money valuation. The company is later sold for $24m. Since no additional investments were made between the time the investor entered the company and the time it was sold, the investor holds 50% of the company. Without having participating preferred rights, the investor would get 50% of the return, or $12m. But with Participating Preferred shares, the investor gets their $6m back and then get 50% of the remaining $18m ($9m), resulting in a total of $15m for the series A investor, which gets more than 50% of the exit value.
many investors want to receive participating preferred shares; however, we believe this “double dipping” is myopic, bad for the company and also affects future funding rounds.
Later Funding Rounds: Now It Gets Interesting
It’s fairly simple to understand liquidation preferences when dealing with the Series A round. Where it gets more interesting and more complex is when a company matures, raising more rounds and therefore creating more classes of preferred shares. Now the liquidation preference needs to be figured out among the generations of investors (Series A, Series B, Series C etc).
There are two options. Either all investors are treated equally — the liquidation preference is provided to all, or preferences are stacked, with the later generations of investors getting their money first. Here’s an example of the preference being provided to all equally:
A company raises $60m in 4 rounds, and each round has a participating preferred feature. The investors own 55% of the company. If the company is sold for $180m, the first $60m would go to the investors. The remaining $120m would entitle the investors to $66m. In this case, investors get $126m ($60m+$66m, or 70% of the proceeds -15% more than they would have received without participating preferred rights).
Excessive liquidation preferences can unfairly reduce the potential value of the equity that management, founders, employees and investors themselves have. The burden of excessive preferences may, over time, hinder the ability of the company to attract quality investors. And eventually, the low potential value of the equity can harm the motivation of management and employees.
Why Participation Overhangs Are a Problem and How to Better Manage Your Cap Table
When early stage investors ask for participating preferred shares, a problem occurs. The next round of investors will (rationally, of course) request the same terms. While all this may be obvious — and raise the question why people ask for or agree to these terms — it remains a common occurrence among some VCs. We see this in term sheets obtained from reputable investors, even though it is very short sighted. I believe that using the mechanism of participating-preferred shares is counter-productive in early-stage financings and creates dis-alignment in the cap table. As stated above, it has serious implications on the ability of the company to raise money.
Entrepreneurs that dream of building large companies and want to be successful at raising money in multiple rounds will need to take care to keep early funding rounds simple — avoid preferences and layers of complexities. So while monetary preferences are a must in venture investing, when using them, take care to avoid the creation of de-facto standards that will gradually become a weight that impedes your ability to raise future funding. If you’re successful — which we all hope you are — you’ll need to raise several rounds of future funding, and that requires an effort to keep the cap table organized and clean.
