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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