Liquidation preferences are an important part of preferred stock terms. Digging a little deeper, there are two basic types of liquidation preferences: “non-participating preferred” and “participating preferred.”
Participating preferred stock entitles the holder to a preferential payment upon liquidation, typically an amount equal to their initial investment, plus accrued and unpaid dividends. In addition, they receive their percentage share of the remaining liquidation proceeds on what is referred to as an “as-converted to common stock basis.”
What this does is allow venture investors to receive both their investment back and a pro rata share of any gains. For example, say a company issued $1 million in participating preferred stock at a $1M pre-money valuation and the company was later sold for $10 million. The holders of participating preferred stock (assuming they were entitled to the typical “1x” liquidation preference) would receive a $1 million liquidation preference, plus accrued and unpaid dividends. The remaining $9M would be divided pro rata (50/50 in this case) between the common stock and the preferred stock, as if the preferred stock had converted to common stock. So, the preferred stockholders would receive their $1M investment back, plus $4.5M of the remaining proceeds, for a total of $5.5M.
Non-participating preferred stock also entitles the holder to the preferential liquidation payment. But they are not entitled to a share of the remaining liquidation proceeds – those proceeds stay with holders of common stock. If a situation arises where preferred stockholders would receive more per share as holders of common stock than holders of preferred stock, preferred stockholders can convert their shares into common stock, giving up their liquidation preference in exchange for the ability to share pro rata in the total liquidation proceeds. So, in the above-example, the preferred stockholders could elect to either receive their $1M investment back or 50% of the $10M proceeds ($5M). Obviously, they would convert and receive $5M, which is almost 10% less than they would have received if the preferred stock had participation rights.
It is worth noting that different series of preferred stock might be inclined to convert to common stock at different transaction values, as there are different preference amounts per share for the different series. This can lead to the need for complex spreadsheets that model what happens upon the sale of a company at different transaction values.
The issue of participating preferred stock is one of the important differences between east coast and west coast deals (it is a deal term more commonly found on the east coast) and can impact which firm a startup chooses as it seeks venture capital.
There are arguments for and against participating preferred stock. Preferred stockholders argue that they need to ensure a minimum return on their investment and participation rights prevent common stockholders from pursuing a sale that isn’t a home run for the investors, as the common stockholders would receive nothing unless there is both a return of the investors’ investment and further proceeds to be divided between common and preferred stockholders. Common stockholders might argue that participating preferred allows the holders to essentially double-dip into the proceeds. This has the effect of reducing the amount of money left for founders and other employees. One counter to that is when a company is sold shortly after the investment, the founders, who likely paid much less than holders of preferred stock, can get a significant return on their investment, while preferred stockholders get little return. This is especially true if there is a “1x” liquidation preference (sometimes if a company is distressed at the time of a financing, the liquidation preference is much higher, often 5x). To bridge the gap, a cap on participation rights is often inserted that both parties agree represents the point at which the founders have provided such a great return to the investors that the investors should no longer retain participation rights and only receive their pro rata portion of any sale proceeds. The cap is usually between 3x and 5x. So, in the above example, if the cap is 5x, the participation right would terminate and the investors would only receive 5x. But, if the sale was only for $5M (rather than $10M), the investors would receive $1M, plus 50% of the remaining $4M, for a total of $3M.
Either way, emerging companies should be aware of the potential implications of participating preferred stock during negotiations and recognize that it is a deal term that requires careful thought and negotiation. Otherwise, founders risk giving investors a larger share of sale proceeds than they might have intended.