I’m a VC/startup lawyer with a budding interest in blogging, so naturally I was attracted to startupSD. Before I go on I have to give the legal disclaimer: nothing I say should be held against me (or my firm), and this blog isn’t legal advice. If you need legal advice, call a lawyer (I know a few)!
With that out of the way, I figured a good way for me to add value on the site was to post a few blogs to help de-mystify some of the terms in VC term sheets. You’re probably dying to get a term sheet from a VC, but this is a case where you should be careful for what you wish for. As soon as you get one, the question is what the heck do the terms mean and what’s important and what’s not? If this post gets some positive feedback and is considered useful, I’ll de-mystify other terms with future posts. So feel free to comment below.
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One dirty little secret among VC lawyers is that there’s a relatively standardized set of terms and forms for VC deals. Not all VCs or their lawyers rely on them, but the forms on the website of the National Venture Capital Association, including their term sheet, are very helpful in getting yourself an education as to what terms mean, what the choices are between VC friendly and entrepreneur friendly, and some middle-ground solutions. You should be aware that the forms, not surprisingly, are VC friendly out of the box, but they’re useful for entrepreneurs to begin to educate themselves nonetheless.
VC Term Sheet Term of the Day: “Participating Preferred”
What is “Participating Preferred”: the Short Answer
What does “participating preferred” mean? The short answer is that it’s the VC-friendly version of a liquidation preference in a VC financing, compared to the company-friendly version, a 1X non-participating preferred. If that sounds like jargon to you, check out the longer answer below.
The More Detailed Answer
To back up, VC investments, at least ones for equity (instead of convertible debt, a subject for another day), are usually made through investing in convertible preferred stock. “Convertible” means it’s convertible into common stock, usually on a one share of preferred to one share of common basis. “Preferred” means is that this stock has special rights compared to the common stock it can convert into. Those preferences could conceivably be anything, but in the VC world there’s a fairly standard set. And the main right is a liquidation preference. Because these rights are specific to the preferred, they’re lost if the holder decides to convert into common stock.
A liquidation preference is what it sounds like: if the company has to liquidate, the “preferred” get a “preferential” payment before the common stock does. You may think that’s not likely to be relevant to you, because if the company liquidates, the game’s over anyway. And in many cases that will be true. But consider this: VC term sheets define liquidations to include a sale of the company. So we’re not only talking about payment on the “downside” of a liquidation, but the “upside” when that big multi-national notices your technology and is willing to pay big dollars to snap you up. Perhaps it’s not a surprise, but in that instance, the VCs will get paid before the founders due to the preferred’s liquidation preference.
A liquidation preference can be any amount. Traditionally (and currently) that preference is usually set at what the investors originally paid. Back in the tech meltdown, venture investments were seen as riskier than they’d been during “the bubble,” so in that dark and uncertain period, not only did VCs ask for their money back, they asked for multiples of three to five times their money back before any money went to the common. If the economy continues to slow, we may see VCs start asking for these multiples again, but for now I’m still seeing 1X liquidation preferences, or in other words, VCs being entitled to their money back first, but not more.
Here’s the deal. Imagine again you’re selling your company in a deal that’s a big winner. A really big winner, where the common stock is going to get many times more than the preferred is with their 1X liquidation preference. For illustration’s sake, let’s say the company sold 1 million shares of Series A at $5 each, and there were another 4 million shares of common outstanding. If the preferred don’t convert into common, all they’ll get is their 1X payment (or $5 per share), while if they do convert, they’ll get twice that ($50 million divided by 5 million shares = $10 per share). So in this scenario they’ll obviously convert to common, in the process losing that initial liquidation preference. Why not, the enterprising VC and their lawyer wondered to themselves, get our cake and eat it too? Why can’t we have both the liquidation preference and participate with the common? And the answer is, of course they can, if the VC asks for participating preferred and the founders agree.
So what “participating preferred” means is that the preferred gets its initial liquidation preference back first, then it participates with the common as-if it had converted. In our $50 million sale of the company, rather than the $10 per share the preferred would get under non-participating preferred, the first $5 million would instead all go to the Series A, then the Series A and the common would be treated as equals for distribution of the remaining $45 ($45 million divided by 5 million shares yields an additional $9 per share). That sums to a total of $14 per share to the preferred and $9 per share to the common.
As a result of this math, VCs will most often want to get participating preferred. It’s always better for them. Entrepreneurs and their lawyers have learned to push back, but success in this negotiation depends on negotiating leverage, and the one with the upper hand usually wins. Doing a deal requires two interested parties, but someone is often more interested than the other, and they’ll probably be the one that gives up on this point.
Somewhat of a Middle Ground
Since non-participating is “company-friendly,” and participating is “VC-friendly,” the obvious question is whether there’s a middle ground. And the answer is a qualified “yes.” Sometimes investors and companies will settle on a “capped” participating preferred, where the participation is capped at 3X to 5X the original investment. This will only come into play where the deal is rich enough to get above these levels. For example, using our stock numbers above, imagine that the deal is for $100 million instead of $50 million. With participating preferred, the preferred gets the initial $5 million then gets another $19 per share ($95 million divided by 5 million shares), for a total of $24 per share for the preferred, and $19 per share for the common. If the participation were capped at 3X, the preferred would get a maximum of $15 per share back and the common would get $21.25 ($85 million divided by 4 million shares) each. But again the holders of the preferred would want to convert into common at that point since it yields a cool $20 per share ($100 million divided by 5 million). If there were no cap, there would never be a reason to convert. The preferred would always take the first $5 million and then share the entire upside. But with a cap, once the return hits the cap it can become more lucrative to convert into common, which effectively re-distributes that initial $5 million among all stockholders. In our example, because $20 per share for the common is better than $19, if the company can get capped participating preferred rather than pure participating preferred, the common holders will be better off.
Conclusion and Disclaimer, Again
There are a number of assumptions built into the general statements I make above, so your mileage may vary. And again, you’ll need a good lawyer to walk through your particular situation, on this issue as well as the many others in the Series A term sheet you and your co-founders and employees worked hard to get. But if you get that term sheet, and your lawyer says “they want participating preferred,” now you’ll know that you’re being asked to give up more of the “upside” than you would if you got the VCs to accept non-participating preferred. And if you can’t move the VC back to non-participating, you may be able to at least cap the participation and re-capture some of that upside should your company be a huge winner. So best of luck, and be safe out there!