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Liquidation Preferences and Participating Preferred Stock: How VC Terms Affect Deals

In this tutorial, you’ll learn about common terms in venture capital investments, such as liquidation preferences and participating preferred stock, and you’ll get simple Excel examples that demonstrate how they affect the distribution of proceeds in M&A deals. Resources: https://youtube-breakingintowallstree... https://youtube-breakingintowallstree... Table of Contents: 0:00 Introduction 1:24 The Short Answer 5:25 Part 1: Company Ownership 8:51 Part 2: Liquidation Preferences 15:57 Part 3: Participating Preferred Stock and Participation Caps 28:29 Recap and Summary When VCs invest in startups, they normally do so by purchasing preferred stock rather than common stock. If a VC has preferred stock, and a startup sells itself or shuts down, the VC may choose to keep the preferred stock and its special terms or convert to common stock. All else being equal, the VC will choose the option that results in the highest proceeds. In M&A deals, these VC deal terms affect the advice you give clients because they change the distribution of proceeds. For example, maybe VC Firm A and VC Firm B each own 25% of a company on paper, but because of these terms, if the company sells for $100 million, VC Firm A could end up with $25 million, while VC Firm B gets $40 million. Company Ownership Calculations You normally start this analysis by plotting out what happens in each outside funding round. The main point here is that the number of common share equivalents after each funding round equals the number before the round, divided by (1 – the new ownership created or granted). So, if there are 5 million shares before the funding round takes place, and VC investors buy 1/3 of the company, there will be 5 million / (1 – 1/3) = 7.5 million shares after the round takes place. You use this principle to calculate the share count after each round and each investor’s ownership as the company raises more funding. Liquidation Preferences This term means that if a VC investor keeps its preferred stock when a “liquidation event” occurs, it will receive a fixed dollar amount (up to the amount the exit proceeds can cover). This fixed amount is almost always a multiple of the initial investment, such as 1x, 2x, 3x, etc. If the exit proceeds cannot pay for all the liquidation preferences, payments will be made in order of seniority (the most recent investors are usually the most senior). Liquidation preferences protect later-stage VCs from investing in a company at a $100 million valuation, only for the company to sell itself for $80 million, or some price less than $100 million. If there are only a few investors with simple liquidation preferences and nothing else, the calculations are simple: Step 1: Calculate each VC Firm’s exit proceeds if they were to convert into common stock. Step 2: Pay out the greater of these common stock proceeds or each VC’s liquidation preference, up to the total remaining proceeds available. Step 3: Everything left after these VC payouts goes to the common shareholders (the Founders, management, employees, etc.). Participating Preferred Stock and Participation Caps This term allows the VC to “double dip” by earning its liquidation preference and “participating” by getting a percentage of the common shareholder proceeds (if it keeps its preferred stock). It heavily skews the exit proceeds in favor of the VCs, so if this term exists, there is usually a participation cap, such as 2x or 3x, that limits the VC’s total proceeds to a multiple of their liquidation preference. The decision-making process here can be complicated because each investor group’s actions will affect the best decisions for the other groups, so you normally model out all the possibilities to determine the optimal decision set. Step 1: Calculate each VC Firm’s exit proceeds if they convert to common stock, and fill in the participation cap and other terms. Step 2: Calculate and deduct all the liquidation preferences from the exit proceeds based on the conversion decisions (e.g., only deduct these if the investor keeps its preferred shares). Step 3: Calculate and deduct the Participating Preferred Proceeds based on the conversion decisions and participation caps. Step 4: Recalculate the common shares and ownership after these distributions based on which investors have converted into common shares or kept their preferred shares. Step 5: Distribute the remaining proceeds to the common equity investors based on their ownership percentages. If some VCs have converted into common shares, they count as “common equity investors” in this last step.