We’ve seen several M&A deals collapse unexpectedly in the past two months. Each was at the signed LOI stage. There was no warning or evidence of an issue until the moment the CEO got the phone call from the acquirer saying the deal was off. In both cases, the explanation was vague.
I’ve also seen several financings fail to close recently. Two of them were late stage financings that were pulled by the investor at the last second. One of these investors is highly visible for doing late stage deals. The other was an investor I didn’t know much about. The explanation I heard from the founder in each case was again vague.
In contrast, we closed a deal in two weeks last month. The person on the other side was willing to give us a lower price in exchange for “deal certainty”, explicit words that she used. We are very pleased with the deal and the price and appreciated that our reputation for just getting it done resulting in a significantly lower price. Deal certainty has always been important to me and I expect it’ll become even more important in the next year.
You will be seeing a lot more deals that don’t get closed after the handshake, verbal agreement, or even a signed non-binding LOI. This is natural in this part of the cycle, when prices feel high to investors, there is a lot of competition for deals, and a goal of some investors and acquirers is to get an LOI or term sheet signed with an exclusivity period in order to give them time to make a decision.
There are also a lot of unsophisticated buyers and investors out there. They generally don’t value deal certainty, especially if they come from other industries where lots of deals fall apart.
At this stage, it’s very important that the founders, whether they are selling their company or raising money, know the experience of the buyer or investor. You need to know their process. You need to know their investors, especially if it’s a private company buying another private company. Understand the history of their deal execution. Ask about, and understand the process from LOI / term sheet to close.
Basically, don’t be naive. There are lots of investors and acquirers out there who have low to medium deal certainty. There are others how have high deal certainty. Do your work and know who you are dealing with before you engage in the process for real.
While price is usually first issue on every seller’s mind, structure should be second. While there only two types of deals (asset deal vs. stock deal), there are numerous structural issues surrounding each deal. Rather than trying to address all the different issues, Jason and I decided to start by discussing the basics of an asset deal and a stock deal.
In general, all sellers want to do stock deals and all buyers want to do asset deals. Just to increase the confusion level, a stock deal can be done for cash and an asset deal can be done for stock – don’t confuse the type of deal with the actual consideration received (if you start getting confused, simply think of an asset deal as a “artichoke deal” and a stock deal as a “strawberry deal.”)
Sarcastic venture capitalists on the seller side will refer to an artichoke deal as a situation “when buying a company is not really buying a company” (kind of like eating the artichoke leaves but leaving the artichoke heart untouched.) Buyers will request this structure, with the idea that they will only buy the particular assets that they want out of a company, leave certain liabilities (read: “warts”) behind, and live happily ever after. If you engage lawyers and accountants in this discussion, they’ll ramble on about something regarding taxes, accounting, and liabilities, but our experience is that most of time the acquirer is just looking to buy the crown jewels, explicitly limit their liabilities, and craft a simpler deal for themselves at the expense of the seller. We notice that asset deals are more popular in shaky economic times, as acquirers are trying to avoid creditor issues and successor liability. One saw very few asset deals (in proportion) in the late 1990’s, but in early 2000 artichokes became much more popular and there is still a significant hang over today.
While asset deals are “ok” for a seller, the fundamental problem for the seller is that the “company” hasn’t actually been sold! The assets have left the company (and are now owned by the buyer), but there is still a shell corporation with contracts, liabilities, potentially employees, and tax forms to file. Even if the company is relatively clean from a corporate hygiene perspective, it may take several years (depending on tax, capital structure and jurisdictional concerns) to wind down the company. During this time, the officers and directors of the company are still on the hook and the company presumably has few assets to operate the business (since they were sold to the buyer).
In the case of a strawberry deal, the acquirer is buying the entire company. Once the acquisition is closed, the seller’s company disappears into the corporate structure of the buyer and there is nothing left (except possibly some t-shirts that found their way into the hands of spouses and the company sign that used to be on the door (oops – did I say that?) just before the deal closed.) There is nothing to wind down and the historical company is well – history.
So is an asset deal “bad” or is it just a “hassle”? It depends. It can be really bad if the seller has multiple subsidiaries, numerous contracts, employees with severance commitments, disgruntled shareholders, or is close to insolvent. In this case, the officers and directors may be taking on fraudulent conveyance liability by consummating an asset deal. It’s merely a hassle if the company is in relatively good shape, is very small, or has few shareholders to consider. Of course, if any of these things are true, then the obvious rhetorical question is “why doesn’t the acquirer just buy the whole company via a stock deal?”
In our experience, we see stock deals the vast majority of the time. Often the first draft of the LOI is an asset deal, but as sellers that is the first point we raise and we are generally successful ending up with strawberries except in extreme circumstances whereby the company is in dire straits. Many buyers go down a path to discuss all the protection they get from an asset deal – this is generally nonsense as a stock deal can be configured to provide functionally equivalent protection for the buyer with a lot less hassle for the seller. In addition, asset deals are no longer the protection they used to be with regards to successor liability in a transaction – courts are much more eager to find that a company who purchase substantial assets of another company to be a “successor in interest” with respect to liabilities of the seller.
The structure of the deal is also tied closely to the tax issues surrounding a deal and – once you start trying to optimize for structure and tax – you end up defining the type of consideration (stock or cash) the seller can receive. It can get complicated very quickly and pretty soon you can feel like you are climbing up a staircase in an Escher drawing (or running the Manhattan part of the New York Marathon – each time you turn you expect to get to go downhill and see the end, but instead you continue to wind uphill forever – even when you’ve turned 180 degrees and are running the other direction.) We’ll dig into tax and consideration is other posts – just realize that they are all linked together and usually ultimately impact price which is – after all – what the seller usually cares most about.
The retrades have begun. Since the beginning of the year, I’ve experienced four retrades – two early stage, one growth, and one late stage – and I’ve heard of a number of others.
If you’ve never experienced a retrade, or don’t know what I’m talking about, it’s the situation when you have a firm deal agreed upon or a term sheet signed and are proceeding to closing a deal, when the investor (or acquirer) decides to change the terms of the deal. And, in case you were wondering, it’s always to make the terms worse, not better.
This happens regularly in M&A deals especially with buyers who are buying thinly capitalized companies or ones who don’t care about their long term reputation. It’s very prevalent with buyers who over time get the reputation as bottom feeders and is often something floated during the diligence process to test the conviction of the seller.
However, for the past six years or so, I haven’t seen retrades from VCs or angels investing in companies very often. Occasionally a deal will fall apart in diligence, some famously so, but they rarely have been retraded.
This lack of retrades, however, is not the historical norm. When I started investing in the 1990s, I experienced a lot of retrades from VCs at many different stages. While a term sheet isn’t binding, part of the reason it tended to be long and complicated was to avoid the retrade dynamic and spell out all the terms of the deal explicitly.
In the late 1990s into the mid 2000s, I viewed the risk of a retrade as continuous background noise in any deal – investment or M&A. The notion of deal certainty became important to me and I started spending more time working with investors and acquirers who I believed had a very high likelihood of following through on what they said they were going to do. In contrast, once I found myself being retraded by someone, I noted it and had a higher bar for working with them going forward, since I expected there would be a future likelihood of a retrade if I did something with them.
By the late 2000s, I had stopped being emotional about the notion of a retrade. I viewed it as a normal part of business, which impacted an investor or acquirer’s long term reputation, but was woven into the fabric of things.
And then the retrades more or less stopped. From 2010 forward, the entire VC market shifted into a mode that many describe as “founder friendly.” Investor reputation mattered at both the angel and VC level. Retrades were a huge negative mark on one’s reputation and word got around. As more and more investors showed up, valuations increased, and time to close a deal shortened, there was little tolerance for a retrade, so they disappeared.
As we are now about five months into a broad market reset, both for public and private market valuations, the retrade has reappeared in private investments. The first indicator of it is that it now takes longer for a deal to close. I expect the days of transactions closing 15 days after a term sheet is signed are probably gone for a while. While some lawyers are breathing a sigh of relief, a deal that takes more than 30 days to close often starts to have a little bit of retrade risk. And, when a deal stretches out over 60 days, there’s a lot of risk around deal certainty – both retrade as well as a full deal collapse.
Recognize that I’m talking about investments, not acquisitions. I never saw the retrade dynamic go away with certain buyers and certain type of acquisitions. However, what’s notable to me on the investment side is that the retrade is happening up and down the capital stack.
Jason and I have engaged in a little foreplay with you in our Letter of Intent series. While you might think the length of time that has passed since my last post is excessive, it’s often the length of time that passes between the first overture and an actual LOI (although there are plenty of situations where the buyer and the seller hook up after 24 hours, just like in real life.)
As with other “transactions”, there’s a time to get hot and heavy. In most deals, there are two primary thing that the buyer should have on his mind – price and structure. Since the first question anyone involved in a deal typically asks is “what is the price?” we’ll start there.
Unlike in a venture financing where price is usually pretty straightforward to understand, figuring out what the “price” is in a merger situation can be more difficult. While there is usually some number floated in early discussions (e.g. “$150 million”), this isn’t really the actual price since there are a lot of factors that can (and generally will) effect the final price of a deal by the time the negotiations are finished and the deal is closed. It’s usually a safe bet to assume that the “easy to read number” on the first page of the LOI is the best case scenario purchase price. Following is an example of what you might see in a typical LOI.
Purchase Price / Consideration: $100 million of cash will be paid at closing; $15 million of which will be subject to the terms of the escrow provisions described in paragraph 3 of this Letter of Intent. Working capital of at least $1 million shall be delivered at closing. $40 million of cash will be subject to an earnout and $10 million of cash will be part of a management retention pool. Buyer will not assume outstanding options to purchase Company Common Stock, and any options to purchase shares of Company Common Stock not exercised prior to the Closing will be terminated as of the Closing. Warrants to purchase shares of Company capital stock not exercised prior to the Closing will be terminated as of the Closing.
Hmm – I thought this was a $150 million dollar deal? What does the $15 million escrow mean? The escrow (also known as a “holdback”) is money that the buyer is going to hang on to for some period of time to satisfy any “issues” that come up post financing that are not disclosed in the purchase agreement. In some LOIs we’ve seen extensive details, in so much as each provision of the escrow is spelled out, including the percentage of the holdback(s), length of time, and carve outs to the indemnity agreement. In other cases, there is mention that “standard escrow and indemnity terms shall apply.” We’ll discuss specific escrow language later (e.g. you’ll have to wait until “paragraph 3”), but it’s safe to say two things: first, there is no such thing as “standard” language and second, whatever the escrow arrangement is, it will decrease the actual purchase price should any claim be brought under it. So clearly the amount and terms of the escrow / indemnity provisions are very important.
Well – that working capital thing shouldn’t be a big deal, should it? True – but it’s $1 million. Many young companies – while operating businesses – end up with negative working capital at closing (working capital is current assets minus current liabilities) due to debt, deferred revenue, warranty reserves, inventory carry costs, and expenses and fees associated with the deal. As a result, these working capital adjustments directly decrease the purchase price in the event upon closing (or other pre-determined date after the closing) that the seller’s working capital is less than an agreed upon amount. Assume that unless it is a “slam dunk” situation where the company has clearly complied with this requirement, the determination will be a battle that can have a real impact on the purchase price. In some cases, this can act in the seller’s favor to increase the value of the deal if they have more working capital on the balance sheet than the buyer requires – often the seller has to jump through some hoops to make this happen.
While earn outs sound like a mechanism to increase price, in our experience, they really are tool that allows the acquirer to under pay at time of closing and only pay “true” value if certain hurdles are met in the future. In our example, the acquirer suggested that they were willing to pay $150 million, but they are only really paying $100 million with $40 million of the deal subject to an earnout. We’ll cover earnouts separately, as there are a lot of permutations, especially if the seller is receiving stock (instead of cash) as their consideration
In our example, the buyer has explicitly carved out $10 million for a management retention pool. This has become very common as buyers wants to make sure that management has a clear and direct future financial incentive. In this case, it’s explicitly built into the purchase price (e.g. $150 million) – we’ve found that buyers tend to be split between building it in and putting it on top of the purchase price. In either case, it is effectively part of the deal consideration, but is at risk since it’ll typically be paid out over several years to the members of management that continue their role at the acquirer – if someone leaves, that portion of the management retention tends to vanish into the same place lost socks in the dryer go.
Finally, there’s a bunch of words in our example about the buyer not assuming stock options and warrants. We’ll explain this in more detail later, but, like the working capital clause, can affect the overall value of the deal based on what people are expecting to receive.
I’ve been having a blast with Brad Feld’s Amazing Deals which was created by Deal Co-op, a recent graduate of the TechStars Seattle program. Last week’s deal – the Agloves – ended up getting picked up on Lifehacker and the limit of 500 gloves were sold (at 50% off) overnight! As part of the experience, I’m learning a lot about the Daily Deal business, how it works, what the actual economics are, and what the friction points are.
The latest Brad Feld’s Amazing Deal is now online. We’ve got a great one this week. You can purchase a $70 voucher for use on the Trek Light Gear website for $39. Trek Light has lots of great stuff, including some of the nicest hammocks you’ll ever see. We priced this deal to allow you to purchase their best selling Double Hammock, but you can also use it on other gear.
If you are interested in running a deal on the Brad Feld store, helping bring great deals to readers of this blog while helping me better understand the Daily Deal marketplace dynamics, let me know. I’m looking for deals that can be bought online and shipped nationally and that appeal to a high tech audience.
SRS Acquiom and Pledge 1% have teamed up to created EscrowUP by SRS Acquiom. As investors in SRS Acquiom and members of Pledge 1%, we are excited about the creative idea the two organizations have come up with to increase charitable giving as a result of merger transactions.
When one company buys another, a portion of the proceeds (usually between 10% and 20% of the deal) goes into an escrow account for a period of time (usually a year or two). This escrow is used to cover any undisclosed or agreed to liabilities that come up for this period of time after the transaction. One of the shareholders, called a shareholder rep, is responsible for managing all the activity on the sellers side. It’s a thankless task and a number of years ago my partner Jason Mendelson helped create SRS Acquiom to address this. Instead of a VC, board member, or founder being the shareholder rep (and doing what can turn into a lot of work for free), you can now outsource this to SRS Acquiom.
The money kept in escrow is typically held by a bank. Not surprisingly, the bank makes a spread on the money for doing nothing other than holding the money. Often, the accounts are interest free because it makes tax and accounting easier, and the interest on the escrow accounts isn’t material in the context of the individual deal. But, the numbers across multiple deals adds up. Therein lies and interesting opportunity.
Imagine the following situation: Assume GiantCorp agrees to buy AwesomeStartup for $1 billion. As part of the deal, GiantCorp insists that $100 million of the $1 billion (10%) be put in escrow for 18 months after closing to ensure everything AwesomeStartup represented about its business is true.
GiantCorp and AwesomeStartup could agree that the escrow will either go into an interest bearing or non-interest bearing account. Whatever they select, they get the same terms with EscrowUP as they would without it so there is zero impact to them. But if they agree to have it participate in EscrowUP, then money goes to charity.
That money comes from SRS Acquiom, not out of the deal parties’ pockets. SRS Acquiom gives a portion of their revenue (up to 24 basis points) from the deal to the awesome group of designated charities that support entrepreneurs.
The result is that up to $360,000 would to go to the designated nonprofits from this single example deal of GiantCorp buying AwesomeStartup. If lots of deals join in, it drives many millions to Pledge 1% and the other nonprofits.
For a different summary, Erin Griffith wrote a good article in Fortune titled How the Merger Boom Can Drive Donations to Charity.
Last week, a private equity group led by KKR, Bain Capital, and Merrill Lynch announced that they were acquiring HCA for $33 billion. HCA is the largest hospital operator in the United States, owning or operating 176 hospitals, 92 freestanding surgery centers and facilities for outpatient and ancillary services in 21 states, England and Switzerland.
Stan Feld (my dad – a retired endocrinologist and – among other things – the inventor of “the neck check“) – who has been writing a blog for several months titled Repairing the Healthcare System – sees this deal as another step backward. He’s spent the past few months deconstructing the problems with today’s healthcare system in the US and is starting to put together the building blocks for his solution. He shines a light on some of the potential second order effects of a deal like this which he concludes:
If I am correct, rather then decreasing the cost of care through efficiency of care and an increased quality of care to decrease complications of chronic disease, we will see an increase in cost of care.
The deal is far from done and there’s plenty of chatter about other potential syndicates forming to make an offer along with the predictable shareholder lawsuits to block the deal, presumably with the goal of increasing the price on the deal. Regardless of the ultimate outcome, the largest private equity deal to date will undoubtably be interesting to watch unfold.
Earlier this week I did a brief post on the “no shop agreement” that is a common feature in a term sheet. I compared signing a no shop to the construct of serial monogamy in a relationship. I had a couple of comments (one that was intellectual, one that was a little harsher and painted VCs as “duplicitous.”) I was mulling over my obviously (in hindsight to me) asymmetric view when Tom Evslin very clearly and coherently articulated why my analogy was really unilateral monogamy (e.g. the VC isn’t signing up for serial monogamy – only the entrepreneur is.)
Tom – and the comments I received – are correct (although I don’t agree with the generalization that “VCs are duplicitous.”) After reading Tom’s post, I thought about my own behavior (at least my perception of my own behavior) vs. the general case and realized I’ve mixed the two up. I’ve been on the giving and receiving side of unilateral no shops many times and – when on the receiving side – have usually been sensitive to why the other party wouldn’t sign a reciprocal no shop. In most cases, I simply don’t put a lot of weight behind the no shop due to the ability to bind it with time (30 – 45 days), plus whenever I’m on the receiving end, I’ve done my best to test commitment before signing up to do the deal.
In addition to Tom’s post, Rick Segal wrote up his thoughts in a post titled “The Handshake Clause” where he makes the point that his firm doesn’t sign a term sheet until they are committed to doing a deal. His explanation of how he approaches this is useful, but it is important to acknowledge that there is a wide range of behavior among VCs – the group that doesn’t put a term sheet down until they are committed are at one end of the spectrum; the group that puts down a term sheet to try to lock up a deal while they think about whether or not they want to do it is at the other. I’d like to think that we are at the “good” end of this spectrum (e.g. we won’t issue a term sheet unless we are ready to do a deal.) Obviously, your mileage will vary with the VCs you are dealing with – hence the value of doing your own due diligence on your potential future partners.
As I mulled this over, I came up with a couple of examples in the past 10 years where the no shop had any meaningful impact on a deal in which I was involved. I could come up with an edge case for each situation, but this was a small number vs. the number of deals I’ve been involved in. In addition, when I thought about the situations where I was a VC and was negatively impacted by not having a no shop (e.g. a company we had agreed with on a term sheet went and did something else) or where I was on the receiving end of a no shop and was negatively impacted by it (e.g. an acquirer tied me up but then ultimately didn’t close on the deal), I actually didn’t feel particularly bad about either of the situations since there was both logic associated with the outcome and grace exhibited by the participants. Following are two examples:
- We signed a term sheet to invest in company X. We didn’t include a no shop in the term sheet – I don’t think there was a particular reason why. We were working to close the investment (I think we were 15 days into a 30–ish day process) and had legal docs going back and forth. One of the founders called us and said that they had just received an offer to be acquired and they wanted to pursue it. We told them no problem – we’d still be there to do the deal if it didn’t come together. We were very open with them about the pros and cons of doing the deal from our perspective and – given the economics – encouraged them to pursue it (it was a great deal for them.) They ended up closing the deal and – as a token – gave us a small amount of equity in the company for our efforts (totally unexpected and unnecessary, but appreciated.)
- I was an existing investor in a company that was in the process of closing an outside led round at a significant step up in valuation. The company was under a no shop agreement with the new VC. Within a week of closing, we received an acquisition overture from one of the strategic investors in the company. We immediately told the new lead investor about it who graciously agreed to suspend the no shop and wait to see whether we wanted to move forward with the acquisition or the financing. We negotiated with the acquirer for several weeks, checking regularly with the new potential investor to make sure they were still interested in closing the round if we chose not to pursue the acquisition. They were incredibly supportive and patient. The company covered their legal fees up to that point (unprompted – although it was probably in the term sheet that we’d cover them – I can’t recall.) We ended up moving forward with the acquisition; the new investor was disappointed in the outcome but happy and supportive of what we did.
As I said earlier, these are edge cases – in almost all of my experiences the no shop ended up being irrelevant. But – as both of these example show – the quality and the character of the people involved made all the difference. Near the end of his post, Tom makes the point that it’s “good negotiating advice to make sure that every clause which can be mutual is mutual.” I completely agree.
The latest Brad Feld Amazing Deal is online.
A few weeks ago I was approached by Sympoz, a company in Boulder that is excited about building online classrooms where anyone can take a courses in categories like Wine, Personal Finance, Cooking, etc. The have a nice looking site, and their classes are self serve, at your own pace, in HD. They have forums where you can interact with fellow classmates and teachers. Classes range in price from $39 to $99.
They asked me what I thought, and I told them I thought they should offer up some classes on my Brad Feld’s Amazing Deal Store. They agreed to give my readers a great deal. $19 for any class that in their inventory. And, I’m putting my money where my mouth is – I just bought (using my Amazing Deal site) the Wine Demystified course.
If you have a love of learning, or are looking for an interesting gift, give Sympoz a try by purchasing this deal. You could become an wine expert for less than the cost of a decent bottle.
When I wrote my first post on the structure and financial components of a typical venture capital investment – where I described Liquidation Preferences – I alluded to the concept of participating preferred as a maligned and typically hotly negotiated issue in many venture capital investments. In this post, I’m going to try to explain the notion of participating preferred (referred to hereafter as PP), how it works, and its financial and emotional impact on a deal. I’m not going to take sides, but rather try to give a broad perspective on it.
First – some history. I first encountered PP when several of the angel investments that I did in 1994 and 1995 matured to the point where they raised a round of institutional venture capital. Since I was living in Boston at the time, most of the VCs looking at my angel deals were east coast firms. In every single case, the initial term sheets each of these companies received included a PP feature – a “double dip” as my east coast lawyer called it. When we pushed back on the PP, we were told that all east coast term sheets had them (our lawyer told us it was negotiable, but that it was definitely an east coast standard request). The PP survived several of term sheet negotiations, but not all of them.
My east coast-centric world changed significantly after I moved to Colorado in 1996 and started doing venture capital. Because of geography and investment focus, I ended up working on more stuff on the west coast. There, I rarely saw a PP feature and was told flatly that PP was “an east coast term.” As the 1990’s marched on and the bubble started to build, I rarely saw a PP – even the east coast guys had dropped it from their standard term sheets.
After the bubble burst in 2001, PP was back – and this time on both coasts. Suddenly every term sheet I saw had a PP feature in it, regardless of the stage of the investment, type of business, or location of investor. It had once again become “a standard feature”, although it was now bi-coastal (or – more accurately – a red-blooded American term.)
So, with this as background, and before we dig into the actual mechanics of a PP, lets first recognize it for what it is – an economic feature in a venture investment. It’s not a standard term, nor is it something that is evil and should never be part of a deal. Unlike a liquidation preference which is rarely negotiable with a VC, a PP is almost always negotiable. There are even cases where it economically disadvantages an early stage investor who insists on it in the deal from the beginning. Importantly, there is not a consensus among investors on when a PP feature is appropriate in a deal and each firm approaches it from their own, unique perspective.
A PP is the right of an investor, as long as they hold preferred stock, to get their money back before anyone else (the “preference” part of PP), and then participate as though they owned common stock in the business (or, more technically, on an “as converted basis” – the “participation” part of PP). It takes a preferred investment, which acts as either debt or equity (where the investor has to make a choice of either getting their money back or converting their preferred shares to common), and turns it into something that acts both as debt and equity (where the investor both gets their money back and participates as if they had converted to common shares).
To illustrate, let’s take a simple case – a $5m Series A investment at $5m pre-money where the company is sold for $20m without any additional investments being made. In this case, the Series A investor owns 50% of the company. If they did not have a PP, they would get 50% of the return, or $10m. With the PP they get their $5m back and then get 50% of the remaining $15m ($7.5m), resulting in $12.5m to the Series A investor and $7.5m to everyone else. In this case, the Series A investor gets the equivalent of 62.5% of the return (rather than the 50% which is equivalent to their ownership stake). The PP results in a re-allocation of 12.5% of the exit value to the Series A investor.
Obviously, this can get much more complicated as you start to have multiple rounds of investments with a PP feature. A simple way to think about how the economics of a PP works is that the total dollar amount of the preference will come off the top of the exit value (and go to the investors); everyone will then convert into common stock and share the balance based on their ownership percentages. For example, assume a company raises $40m over 3 rounds where each round has a PP feature and the investors own 70% of the company. If this company is sold for $200m, the first $40m would go to the investors and the remaining $160m would be split 70% to investors / 30% to everyone else. In this case, the investors would get a total of $152m, ($40m + $112m, or 76% of the proceeds – 6% more then they would have gotten if there was no PP.)
If you sit and ponder the math, you’ll realize that a PP usually has material impact on the economics in low to medium return deals, but quickly becomes immaterial as the return increases (or – more specifically – as the ratio of the exit value to invested capital increases). For example, if a company is sold for $500m, a $10m PP re-allocates a small portion of the deal ($10m of the $500m) to the investors vs. the $40m of $200m or $5m of $20m in the other preceding examples. As a result, a PP usually only matters in a low to medium return situation. If a company is sold for less than paid in capital, the liquidation preference will apply and the participation feature will not come into play. If a company is sold for a huge amount of money, the PP won’t have much economic impact, as the preference feature of the PP becomes a small percentage of the deal total. In addition, in essentially every case, PP’s don’t apply in an IPO where preferred stock (of any flavor) is typically converted into common stock at the time of the offering.
As PP started showing up in more deals, some creative lawyer came out with a perversion on the preferred feature called a “cap on the participate” (also known as a “kick-out feature.”) In this case, the participation feature of the PP goes away once the investor holding the PP reaches a certain multiple return of capital. For example, assume a 3x cap on a PP in a $5m Series A investment. In this case, the investor would benefit from their PP until their proceeds from the deal reached $15m. Once they reached this level, their shares are no longer counted in the cap structure and the other shareholders share the remaining proceeds. Of course, the investor always has the option to convert their shares to common stock and give up their preferred return (but participate fully in the proceeds). Put another way, at a high enough valuation the investor is better off simply converting to common (in the current example at an exit value above $30m).
Participation caps, however, have a fundamental problem – they create a flat spot in most deal economics where the investor gets the same amount across a range of exit values. If we stay with the example above and assume a 50% ownership for the Series A, the PP would apply until the exit value reached $25m, at which point the investor receives $15m in proceeds. Between $25m and $30m, the investor would continue to receive this same $15m (this is the flat spot – it doesn’t matter whether the exit value is $26m or $29m, the investor would get $15m). At exit values above $30m, the investor would convert to common stock and take 50% of the proceeds (i.e., their as-converted share of the proceeds would exceed the $15m cap so they would be better off converting to common and taking this share of the exit value). This is an odd dynamic, since the common shareholders are clearly not indifferent to exit values in this flat spot, but the investor is (and consider a case where this flat spot was much larger than the one in the example above). Any way you cut it there is misalignment, at least for a range of outcomes, between the investor and the rest of the shareholders.
Another perversion is the “multiple participate”. In this case, the investor gets some multiple of his participate off the top of the transaction. For example, a 3x multiple participate on a $40m investment would mean the first $120m would go to the investor (and then the remaining proceeds would be distributed to the investor and the rest of the shareholders). This type of PP only appeared for a short while when investors were doing recapitalizations without actually going through the mechanics of recapitalizing the company (more about this in a future blog post).
Interestingly, there is a case to be made that PP in early financing rounds can actually end up disadvantaging early investors. The math on this gets complicated very quickly, but if you assume that every subsequent investment round has at least as favorable terms as the initial round (i.e., include a PP if the first round does) and that subsequent rounds include new investors there are many cases where the initial investor is actually disadvantaged by the existence of the PP (they would have been better off to have not put it in the initial round and because of that pushed for its exclusion from subsequent rounds). It’s counterintuitive, but it actually works out this way in a number of very common financing scenarios.
So – if PP simply relates to economics, why is it a term that brings out such emotion in entrepreneurs and investors alike? A close friend of mine who is an extremely successful entrepreneur recently told me “I’ve walked on every investment deal for any company that I’ve run that even smelled of multiple dips of participation – and spit back in the direction the term sheet came from!” We debated back and forth a while. For example, I asked him “would you take $5m for 33% of a company with no participate or 25% of a company with full participate?” He responded “I would go find a deal where I gave up 26.5% without a participate” which, while an emotional reaction, ironically reinforced my point that it was just economics. After pondering this term over the years, I’ve concluded that participating preferred is one of those terms that creates real tension between the entrepreneur and the investor – it forces the acknowledgement by the entrepreneur that a moderate return is not a success case for the investor and at the same time forces the investor to acknowledge that in those moderate cases they believe it is fair to receive a greater percentage of the proceeds at the expense of the entrepreneur.