Preferred Stock Is Like Fastpass
How liquidation preference terms affect payouts for investors and entrepreneurs
The advent of Disneyland’s Fastpass in 1999 changed the game for eager theme park attendees. Guests had planned their park visits to optimize for the most rides and shortest wait times before, but the Fastpass gave them a tool to achieve those goals. Guests could now expedite access to chosen rides and then reinvest that time elsewhere — waiting for a different ride, eating churros, building a droid, etc. By enabling guests to cover more of the park, the Fastpass increased the value and enjoyment of each trip to Disneyland.
Similarly, venture capital investors purchase equity in startups in the form of preferred stock, which functions like a Disneyland Fastpass. In addition to specific negotiated rights — which can include board seats, information rights, and pro-rata rights, to name a few — preferred shares have a feature known as a liquidation preference that, at the time of a liquidity event, ensures capital is returned to preferred shareholders before other classes of shares, much like skipping the line to a ride at Disneyland. The liquidation preference dictates the order in which investors receive their capital and at what multiple of invested capital (most commonly 1x invested capital).
Beyond ensuring that venture investors receive their payout prior to common shareholders, the liquidation preference also dictates the order in which investors receive their payout amongst themselves. To establish this order, investors will agree to one of two methods: standard seniority or pari passu.
Standard seniority means that investors receive their liquidation preference in the reverse order from which they joined the cap table — Series C investors receive their liquidation preference before Series B investors and so on.
Pari passu means that some or all preferred shareholders have the same seniority, thereby receiving their entire liquidation preference simultaneously or, if there is not enough capital, in proportion to their preferred ownership stake (also known as pro rata).
In addition to the liquidation preference, preferred stock carries the designation of participating or non-participating.
Participating preferred shares enable investors to “double dip” in a liquidation event by allowing investors to receive both their liquidation preference and then their pro rata share of the capital distribution.
Non-participating preferred shares give investors the choice to receive their liquidation preference or convert their existing preferred shares into common stock to participate in the capital distribution on a pro rata basis. Investors will choose to convert their shares to common when their pro rata share of an exit exceeds their liquidation preference.
Common shareholders, on the other hand, do not have any of these rights and are generally the last to get paid in a liquidity event. Only after creditors and preferred shareholders have recouped their investment will common shareholders receive their share of any remaining exit proceeds.
Space Mountain: The Startup
With these defined terms, let’s see how each security and preference method works in practice by looking at a fictional startup called Space Mountain. For the sake of simplicity, we will assume Space Mountain raised a $10M Series A from one venture capital investor in exchange for 20% of its equity, implying a $40M pre-money valuation and a $50M post-money valuation (see Figure 1).
We will now illustrate what happens to the investor’s and entrepreneur’s returns in two scenarios with five different types of securities— dubbed Falling With Style and To Infinity and Beyond — based on the investor’s security type, liquidation preference, and participation as laid out in Figure 2. For the purposes of these examples, we will ignore closing costs like investment banker fees, debt repayment, and any other expenses that would deduct from the total proceeds that can be distributed to shareholders.
Scenario 1: Falling With Style — $5M Exit
In this scenario, let’s assume Space Mountain falls on hard times and is acquired for $5M, well below the post-money valuation of the Series A.
If the VC owns common stock in Space Mountain (see Security 1 in Figure 3), it does not have a liquidation preference. As a result, the investor receives its returns alongside all other common investors in proportion to its 20% fully-diluted ownership stake. Therefore, the investor receives $1M (20% of $5M) and other common shareholders receive $4M (80% of $5M). The VC receives 10% of its initial investment, also known as a 0.1x multiple.
If the VC is a preferred shareholder, as seen in Securities 2 through 5 above, the investor does have a liquidation preference, but the exit is not large enough to return the investor’s cost basis. As such, all exit proceeds are allocated to covering as much of the investor’s liquidation preference as possible, with no capital remaining for common shareholders to receive payouts or for participating preferred shareholders to “double dip.” In these scenarios, assuming that there are no debts or closing costs, the investors receive all of the proceeds from the exit. Practically speaking, management may receive a “carve out” in this scenario as motivation to join the acquirer, but this tends to be negotiated closer to an exit and not in a venture capital term sheet. For Securities 2 through 5, the VC receives 50% of its initial investment, a 0.5x multiple.
Scenario 2: To Infinity and Beyond — $100M Exit
In this scenario, Space Mountain is successful and is acquired for $100M.
If the VC owns common stock in Space Mountain (see Security 1 in Figure 4), the investor receives $20M (20% of $100M), in line with its 20% fully-diluted ownership stake, and other common shareholders receive $80M (80% of $100M). The VC receives 200% of its initial investment, a 2.0x multiple.
In the case of non-participating preferred stock (see Security 2 in Figure 4), the VC has the option to receive its $10M liquidation preference or convert its preferred shares to common stock and receive $20M, its share of the proceeds proportional to its 20% fully-diluted ownership stake (20% of $100M). In this case, the VC will convert to common, as $20M is greater than its $10M liquidation preference. The remaining $80M is returned to other common shareholders. As is the case with Security 1, the VC receives 200% of its initial investment, a 2.0x multiple.
In the case of participating preferred stock (see Securities 3, 4, and 5 in Figure 4), we see the investor “double dip.” By investing in Space Mountain through participating preferred shares, the VC recovers its liquidation preference first, and then participates in the remaining capital distribution on a pro rata basis.
For Security 3, the investor receives its 1x liquidation preference, resulting in an immediate return of $10M. Thereafter, the investor receives an additional $18M (20% of the remaining $90M), in line with its pro rata ownership amount. In total, the VC earns a $28M exit, or a 2.8x multiple. The remaining $72M is returned to other common shareholders.
For Security 4, the investor receives its 2x liquidation preference, resulting in an immediate return of $20M. Thereafter, the investor receives an additional $16M (20% of the remaining $80M), in line with its pro rata ownership amount. In total, the VC earns a $36M exit, or a 3.6x return on invested capital. The remaining $64M is returned to other common shareholders.
For Security 5, the investor receives its 2.5x liquidation preference, resulting in an immediate return of $25M. Thereafter, the investor receives an additional $15M (20% of the remaining $75M), in line with its pro rata ownership amount. In total, the VC earns a $40M exit, or a 4.0x return on invested capital. The remaining $60M is returned to other common shareholders.
Understanding securities in a down economy
As shown in the examples above, investing in a startup through preferred shares provides downside protection (in the form of liquidation preference) and upside benefit (in the form of participation) for investors. Therefore, it’s especially important for founders to understand what’s in the term sheet, especially for those who don’t negotiate these deals regularly. Descriptions of preferred and participating preferred can be challenging to decode, so don’t hesitate to ask your lawyer to explain what’s in the term sheet, or to ask your potential investor what was intended, if there’s any ambiguity.
Participation has fallen out of style as terms have shifted to favor entrepreneurs over the past few decades. As noted by TechCrunch and Cooley, however, downturns can be a time when “investor friendly” terms may dramatically affect how exit proceeds are distributed. While investment valuations could adjust downward in proportion to public market performance, multiples of participating preferred can set a precedent for startups. For entrepreneurs, understanding the mechanics of securities and how this affects what you receive in an exit could help you negotiate terms that properly incentivize you and your investors to succeed together. Your startup could be the “ride” that rewards both Fastpass holders and traditional line-waiters alike.
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Kevin Jones is a Senior Associate at Touchdown Ventures, a Registered Investment Adviser that provides “Venture Capital as a Service” to help leading corporations launch and manage their investment programs.
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