Aug 24 2004

To Participate or Not (Participating Preferences)

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.