Participating preferred shares

Over the weekend Fred Wilson posted about his Evolved view of The Participating Preferred.  The use (or not) of participating preferred shares is one of the most important terms in any venture deal and I was keen to read where Fred’s thinking is headed.  It turns out that the place he is moving away from using participating preferred shares and the position he evolved from is much closer to my thinking than the place he has evolved to – something which prompted me to get my own views down in this post.

First the background.  As I said participating preferred terms go to the heart of most venture deals and anybody who is thinking of talking with VCs should get familiar with how they work.

Keeping it simple, there are three main options that companies and their equity investors choose between when they decide to do a deal together – common stock (aka ordinary shares), non-participating preferred and participating preferred.  With common stock an investor gets her equity percentage of the company, with a non-participating preferred share the investor chooses between getting her investment back before anyone else gets anything OR to get her equity percentage, and with a participating preferred share the investor gets her money back AND gets her equity percentage of the remaining proceeds.

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The table above turned out a bit more complicated than I had anticipated when I started creating it, but hopefully it shows how these different types of share work out in practice.  The key take away is that the participating preferred pays out the most to the investor (the preference and the equity), the non-participating preferred comes second, paying out more to the investor than common stock under low exits (when the investor will choose to take the preference rather than the equity) and the common stock comes third, but is the same as the non-participating preferred for high exits.  You will also notice that under high exits it doesn’t make too much difference to anyone, so these structures are all about managing what happens in the downside.

Like I said, this is an important issue for entrepreneurs to get their minds around, and there are complementary explanations (which you will like better if you prefer words to tables) in Fred’s post and on Brad Feld’s blog.

So now to the question at hand – at DFJ Esprit we far prefer to invest in participating preferred shares and we succeed in getting them in most of our deals.  For me this is not an issue of fairness, but one of economics and habit. 

I think that participating preferred and non-participating preferred shares came into use largely because VCs and entrepreneurs have differing views of the relative likelihood of downside and upside scenarios.  In the common situation that the entrepreneur sees a bigger upside and is less worried about the downside these structures allow the investment at higher valuations giving the entrepreneur a greater percentage of the upside and protecting the investor in downside scenarios.  Participating preferred shares offer slightly more downside protection than non-participating preferred shares and hence bridge a bigger gap between investor and entrepreneur views of the likely outcome.

When companies push back on my request for a participating preferred share my response is usually to say I’m happy to invest in common stock if that is what they want, but the valuation will be higher if we can invest in a participating preferred.  This reflects my belief that the issue is one of economics rather than fairness or principles.

I wrote above that the use of participating preferreds is partly one of habit.  I put that because venture funds need to think about lots of deals and the way to do that efficiently is to standardise as many things as possible, including terms like this.  When we talk about deals the default assumption is that the security will be a participating preferred and that enables us to talk about more companies in the limited time that we have together, and also to more easily compare valuations between companies.

There are some problems with participating preferred shares, of which perhaps the worst is the perception amongst some people that because they give a ‘double dip’ to investors (combing preference AND equity), which can cause relationship problems between a VC and the company she has invested in.  My motivation in writing this post is in large part to try and take the emotion out of this debate.  As I said above I think the issue is primarily one of economics and not fairness.

One other problem that can come with preferred shares (both participating and non-participating) is if a company ends up raising a lot of money over a number of rounds and the total preference becomes a large number.  Then if the company catches a cold it can start to look to management as if there is a wall of money in front of them and they won’t get anything from an exit under most reasonable scenarios.  This happens surprisingly frequently and causes big headaches.

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  • You say participating preferred is about downside protection. If so, wouldn’t a more “honest” term sheet just have a 2x non participating preferred clause? It seems to me that a participating preference is really just a way to notch up the preference multiple hoping no one notices!

  • I think the key issue revolves what the entrepreneurs bring to the table at the moment of financing.

    If all they have is some traction and site-specific code then I agree the argument around preferences boils down to valuation.

    But if the company brings potentially valuable IP (patents, code which can be sold-on, etc) then preferences can be very unfair. Imagine a situation where a self-funded team bring such IP to the table and then later down the line, through no fault of the founding team, the company is sold for the value of the preference. The team members not only lose all their equity, but also title to the original IP, which they created with their own time/money.

  • Nick, It seems to me that for two reasons (or possibly three – if I'm lucky in arguing the third) why I favour Freds thinking over your own.

    1) I agree with Fred that Internet businesses have evolved and the capital required to create significant value in web services companies has fallen dramatically. That capital efficiency brings new economies to investing and terms need to evolve to reflect that. This is a structural not “investor” evolved gain and sharing it between investor and promoter seems more reasonable.

    2) With Tax rates swinging against the Entrepreneur and this trend is likely to be a long term one, they won't extract the same tax efficiency on exit as equity investors. There is a sustainable argument around net not gross gains and here again I believe terms sheets should evolve.

    3) My third point is “more sensitive” and bound to glean a reaction: You say for “efficiency” you standardise terms sheets. Handy for you, but it's reasonable for an entrepreneur to expect investors to come to the party (to a degree at least) or VCs increasingly look and act like Banks.

  • A 2x non-participating pref could be an alternative and sometimes is (although rarely), the disadvantage with multiple prefs is that they give the investor a big return before anyone else sees a penny which creates a significant misalignment of interest

  • If I may respectfully disagree – if the company is sold for less than the preference (ie less than the money raised from the investor) then whose fault is it?

    The company has become worth less than the value of the cash that went in, which implies that the IP isn't very valuable.

    Everybody takes risks in these deals.

  • Hi Martin – thanks for the comment- there are no right answers here, so this debate might run and run, my thoughts on your points are:

    1) lower amounts of capital raised make liquidation preferences less of an issue as more value goes to the equity, so the gains are always shared
    2) whilst entrepreneur take home profits are a concern so are investor profits and these have been unsustainably thin on the ground in recent years, but I come back to my main point which is that there is a straight trade off between valuation and preference – less pref = lower valuation
    3) I would argue that VCs do come to the party and that ultimately this is a market where terms have to settle somewhere, we face pressure to get money to work in the same way as entrepreneurs face pressure to raise it. Everyone is just working hard to make his or her own firm work.

  • Your counter argument at (1) is a fair point…..I guess ultimately it's for Entrepreneurs to negotiate / decide between competing offerings.

    (2) I think VCs would struggle to sustain an argument that they're not well rewarded per se, with sometimes eye watering ROI's.

    Where the business model perhaps needs revision is in the ratio of successes to failures. Small efficiency gains would reap material improvements in total practice ROIs. Far better brains than mine have failed on this one however!!

    3) again is subject to market forces – let the buyer beware….

  • I guess they misalign interest if there is a decision on a cheap sale, but the sale does not have to be that high before the entrepreneur gets a return (e.g. £4m pre, £2m investment – any sale above £4m gives other shareholders return) and it's rarely the VC pushing for a cheap sale. It seems to me that it aligns interest in a way – towards at least a medium exit and makes clear there is a cost of capital beyond just returning it. I think once the entrepreneur has sold above the threshold set (be it 2x or whatever) then exit returns should be based solely on equity. Some early stage investments do this with a convertible loan and a coupon – it achieves arguably something similair.

    In your experience Nic, do you think entrepreneurs you deal with would prefere 1x participating over 2x non participating. It would be interesting to see data on a VC portfolio on which option would work out better for whom from a range of exits.

  • Hi Chris – I think most entrpreneurs would prefer a 1x participating to a 2x non-participating, and the reverse would usually be true for us, from a purely economic perspective. I wouldn't underestimate the importance of alignment though, even if it is restricted to low value exits. They happen more frequently than any of us would like and often it is the VC pushing to get out, particularly when management don't make much from a low value sale.

  • Thanks Martin. Some VCs make unbelievable returns, but the average across the industry over the last ten years has been poor. I will see if there is any data on this which I can publish.

  • harryholmwood

    To play devil's advocate a little – I've seen several situations where a VC has lost faith in a sector (or project, team, company, economy etc) and wanted to get out of an investment, and forced through a sale at the preference value against the wishes of the management who end up with nothing.

    To extrapolate a little… your post from a few months ago, “Our model here at DFJ Esprit is more a third make good money, a third return the investment (plus maybe a little bit) and a third return pennies on the pound” – suggests that, since you're using preferred prefs in these deals, whereas 2/3 of the time DFJ has a good return on its money or at least its money back, 2/3 of the time the entrepreneur/initial owners of the business lose pretty much everything?

    Very interesting to see these things from both perspectives 🙂

  • The extra bit of info here is that at low value exits management are nearly always cut into the proceeds alongside the pref stack. This is usually called a management carve out (from the pref stack).

    Also – at a 2-3x return management usually do ok without a carve out.

  • When companies push back on my request for a participating preferred share my response is usually to say I’m happy to invest in common stock if that is what they want, but the valuation will be higher if we can invest in a participating preferred. This reflects my belief that the issue is one of economics rather than fairness or principles.

    Spot on. But would you really be happy to take common. I agree with you that the different structures essentially just boil down to valuation, although I would add a small caveat (which you allude to) is that all other things being equal preferences add complexity that increases exponentially with multiple rounds, especially if they are participating. Complexity has a cost (for everyone) and should be factored in but I'll grant this would be tremendously hard to price, and would suggest that a simple haircut heuristic would be the best cost/benefit for adjusting relative pricing… So back to the agnostic investor: why don't we see more term sheets that actually offer the entrepreneur this choice, ie:

    Dear John Founder,
    Acme Venture Partners is please to offer to invest $5mn in your wonderful company on any of the following terms:
    <ul><li>Common equity at a pre-money valuation of $3mn</li><li>1x Non-participating preferred equity at a pre-money valuation of $5mn</li><li>2x Non-participating preferred equity at a pre-money valution of $8mn</li><li>or Participating preferred equity at a pre-money valuation of $10mn</li></ul> Please take your pick and let us know.
    Yours truly,
    Jim Cash

    Of course I just pulled these numbers out of the air but it should be entirely possible to derive them and indeed would be a good/interesting exercise for the investor as you would need to make certain assumptions about volatility and probable outcomes (time to break out the ol' Monte Carlo) which themselves would be illuminating and also – if everyone was doing it – highlight differences in how various investors perceived the “outcome surface” which would be impossible to derive from point pricing on one structure. ie Two investors could come up with the same price for participating preferred using different assumptions that would yield very different discounts for common.

    As I am too old and short of grey cells (and my son is a couple years away still from writing option pricing models), and like for many derivatives models on Bloomberg where it is less important that the model is “perfect” (meaningless anyway) than the fact it is used by all as a common denominator…could someone please write a calculator and put it online (get BVCA and/or NVCA to sponsor/publicize) that allows anyone to input variables simple or complex (ie return distribution model) and get a “quick and dirty” pricing hierarchy for any given investment opportunity?

  • Doing a deal in common stock is possible for us, but definitely more hassle. I think just about every time I have presented the option of common at a lower valuation the company has gone for the higher valuation.

    In practice I think it would over complicate things if we were to present three options as you describe, both internally for us and for the company.

  • Ok. But I don't really buy the “it would complicate things” line. I'm not suggesting preparing parallel documentation, adding 2 or 3 lines to a term sheet isn't really excessive imo. Actually you'd probably not even need to do this in most cases (except for instance if/when you were in heated competition for a deal) as a pre-term sheet conversation should suffice: ie “which term sheet do you want?” And indeed you would expect most entrepreneurs (being bullish on their upside) to plump for the participating prefs but they would do so without any regrets… And you are either agnostic or you're not. 😉

    As an aside, the two most successful start-ups I've ever invested in – both now multi-billion dollar companies – Betfair & Markit, had extremely simple cap structures. In fact in Betfair's case their is just common – easy peasy. Don't get me wrong, I understand why investors ask for prefs – I usually do too – but all too often I suspect the motivations are not entirely the right ones and having a healthy and quantitative discussion with any entrepreneur about the valuation differences between securities cannot be a bad thing.

  • Fair point. Two slight counter arguments – 1) we aren't totally agnostic and b) time is usually short as term sheet negotiations come to a head

    Sorry to be slow to reply to this.

  • How could you possibly take common stock? That would eliminate your Pro Rata rights, which are the only way you all really make money. let me know if you really would as I'll send everyone your way. Pro rata rights are far more egregious than the participation in terms of incentive misalignment.

  • Hey Scott – we would always create a separate class of shares with additional investor rights (approve new articles, approve the budget etc.) but they would have the same economics as common stock. Maybe I should have made that explicit.

    If by pro-rata rights you mean the right to participate in any future fundraising then you're right, we wouldn't ever give up on those. In the UK these pre-emption rights (as we call them) are enshrined in law, so unless we give them up explicitly they are ours anyway.