Participating Preferred
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
The description of the typical preferred stock instrument obtained by the venture capitalists is not complete without describing a wrinkle in venture finance, of so-called participating preferred stock. If convertible preferred is the instrument of choice, the holder is left with the choice, upon an exit event such as the sale of the entire company, of holding on to the preferred instrument and being paid liquidation preference plus accrued dividends or converting and capturing the upside. Thus, for example, if a venture-capital fund has invested $5 million for 50 percent of a given company in the form of a convertible preferred security convertible into 50 percent of the common) and the company is sold for $5.5 million, the holder of the preferred will, presumably, hang on to it and be paid the bulk of the proceeds to the exclusion of the common stockholders (e.g., the founder). If a company is sold, however, for any number significantly north of $10 million, then it is worthwhile for the convertible preferred to convert into common and share in 50 percent of the proceeds. Participating preferred, on the other hand, is of the "have your cake and eat it too" variety. Thus, the participating preferred is a preferred stock, which, upon sale of the company, takes home its liquidation preference and then converts on as converted basis. The company is sold for, say, $12 million, the participating preferred holder, instead of converting and obtaining $6 million in proceeds, with $6 million going to the common, gets its $5 million back plus accrued dividends of, say, $500,000 and then shares in 50 percent of the remaining $6.5 million. Accordingly, the common shareholders, instead of obtaining $6 million in proceeds, realize only $3,250,000. If the liquidity event is an IPO, again the participating preferred shareholder gets its money back plus accrued dividends from tax proceeds and then holds 50 percent of the common stock, subject to dilution in the IPO.
If the liquidity event is in the hundreds of millions of dollars, the fact that the participating preferred holder gets the first $5 million back does not materially impact the common shareholders' internal rate of return. However, at numbers in the teens, the difference in return to the preferred versus the common is significant. If the participating preferred is capped at say 23x, then the choice has to be made … $5 million back plus 50% of the proceeds, or $8,750,000 but no more than $10,000,000 (2x). IF the sales price is 45 million, the preferred converts and takes 22,500,000 verses 10 plus $175,000,000 or $27,500,000.