Term Sheet Terms of the Week - Preferred Shares

Participating preferred share: a preferred share that is entitled to participating dividends. A participating preferred share can, in effect, be split into two parts: a preferred share part and common share part. The preferred share part entitles the owner to receive a predetermined cash dividend. The common share part represents additional continued ownership in the company.

With participating preferred, a VC investor gets an additional payout that comes after it has exercised its liquidation preference. For example, if an investor owns 20% of a company in the form of participating preferred stock, it will receive the amount it originally invested (its 1x liquidation preference) before any other shareholders are paid. Plus, the investor will receive 20% of the cash left over after everyone else who has a higher priority is paid. Essentially, participation gives the investor the right to double dip – it gets the liquidation preference plus the economic value of the preferred stock as converted to common stock.

Without the participation right (“non-participating preferred“), the investor has to choose: it can either get the liquidation preference amount or the value of its preferred stock as converted to common, but not both. There is no double-dipping.

A compromise position is capped participation, which allows the investor to double dip, but only up to a point. The VC investor is entitled to receive a share of the leftovers based on its stake in the company, capped at a certain multiple of the original investment amount, including the liquidation preference. So, for example, if participation is capped at 3x, the VC investor is guaranteed 1x the investment via the liquidation preference, and may receive up to 2x the investment out of the leftovers. Alternatively, the VC investor can opt to convert to common and receive its share of proceeds alongside common shareholders.

As stated previously, fully participating stock will receive its liquidation preference. This liquidation preference is typically maxed  out at 1.0x. From there, the stock can share in the liquidation on an as-converted basis. As-Converted just means what would happen if the stock were converted into common stock based on a pre-determined conversion ratio. A Capped conversion indicates that  a stock will receive its liquidation preference and then share in the liquidation proceeds up until a certain multiple is reached.

Why Do These Things Matter?

There are three levels of participation: full participation, capped participation, and no participation. The level of participation essentially determines how much control an investor has over their return. Participating & Capped Participating preferred shares have a ceiling as far as return multiples are concerned – an investor can only make so much money based on the investment size(s). Keep in mind that a preferred investor can always convert their shares into common stock whenever they want to, especially if it benefits them. There are very few reasons why a participating preferred share would convert, however, as they have very little reason to do so.

Non-participating preferred shares have a great opportunity to make their money back if the investment goes sour / doesn’t make as much money as it should. However, they are limited in how much they can squeeze out of that liquidation event. These kind of shares are much more limited in their protections, compared to other participating preferred shares.

When multiple rounds of financing come into play, liquidation preferences may be stacked, or prioritized by series (i.e., Series B gets its liquidation preference before Series A does). Alternatively, the different series could get the same priority, or pari passu, and each will receive the same percentage of its liquidation preference returned until the money runs out or until everyone’s liquidation preferences have been met.

The way that a preferred share is executed can also have a large impact on how much liquidity that a common stock will receive during  a liquidation event. This is due to the liquidation preference that pays out preferred stocks in front of common stock. A preferred stock can end up a taking a much larger chunk than other members of the capital stack.