Cap tables can get complicated quickly making Pro-forma and scenario analysis near impossible unless built right from the start. Preferred stock can be complicated and to start lets breakdown how preferred stock works in different common scenarios.
If you have preferred stock on your cap table, do you really know how preferred stock affects your equity? Do not get surprised when it’s too late to go back in time and make changes. Make sure you have it all figured out early.
Understand the mechanics of preferred stock is critical starting with the most widely used preferred terms, what they mean, and how they work.
Preferred securities usually always have a liquidation preference. This means that preferred stockholders have a right to get their money back before anyone else. Preferences are usually expressed as a multiple of the amount of capital invested. If the preferred stock has a “1x” liquidation preference, then preferred shareholders are entitled to receive an amount equal to one time(s) their investment before other shareholders receive any of their investment back.
Usually, if shareholders elect to receive their liquidation preference, they lose their right to participate with the rest of the shareholders. Liquidation Preferences usually only play out in a downside, failed, or negative scenario as a protective measure. In any good scenario, the preferred shareholders will choose to participate according their ownership (pro rata) if the company sells for a profitable amount more than their original investment.
This simple example show’s how this plays out. Suppose a VC Investor bought 100,000 shares of Preferred stock for $5.00 per share, and the Preferred stock has a 1x liquidation preference. Assuming that you own 100,000 shares of common stock, here is what the cap table would look like:
If the company sold for $650,000, my 1x liquidation preference entitles me to $500,000 of proceeds. This means there’s $150,000 left for you, even though we both own 50% of the company.
Now, suppose that the Preferred stock has a 2(x) liquidation preference. The VC Investor owning the 100 shares of Preferred stock is now entitled to one million dollars of the exit proceeds before you get anything even though the VC only invested $500,000. Using the same exit example scenario of $650,000, the VC gets 100% of the proceeds and you get nothing. A liquidation preference of more than 1(x) is less common but does exist.
Now in the original example let us explore when the Preferred stock has a 1(x) liquidation preference when your company sells for $1,500,000. If the VC Investor chose to take the liquidation preference, the VC Investor receives $500,000 of the proceeds, and you get $1,000,000. In this case, the VC would choose to lose the liquidation preference and instead would rather split the proceeds according to our ownership (50/50)so both shareholders get $750,000 each.
What is the value to the owners of Preferred stock with liquidation preference? In one word it is Protection. The value is in protecting the shareholder in a downside scenario. The risk of betting on entrepreneurs, who may have little to no real money invested in the company, is very high, and the liquidation preference is one way to offset some amount of the risk as a trade-off for protection.
Participation rights mean that in addition to taking the liquidation preference, preferred stockholders also participate pro rata in the remaining amount to be distributed in a liquidation scenario.
This example will show us using our same cap table from above, only now the Preferred stock has a 1x liquidation preference and participation rights. If the company sells for $1 million, the liquidation preference again entitles the VC to $500,000 right off the top, which leaves $500,000 left for you.
Because the VC has participation rights, the remaining $500,000 is split between you and the VC based on the overall outstanding ownership percentages of (50/50). This means the VC now gets an additional $250,000 and you get $250,000. In total the VC will get $750,000 and will you get $250,000.
Participation rights (also sometimes called “double dipping”) can add additional upside to the owner of the preferred while still allowing for additional protection. Why would investors get this kind of privilege? In this scenario it becomes even more important that both the common shareholders and the preferred shareholders equally understand the rights and how they affect different scenarios.
A participation cap can be an additional component of the participation rights. The Cap is the limit on the amount of proceeds an investor can receive from participation rights. The term Participation Cap can also be expressed as a multiple of the invested capital. Simply put, this is a hard cap on the amount of additional upside the participation rights can participate in.
For example, if the Preferred stock has participation rights and a 3x participation cap, and there was a liquidity event; then if the preferred shareholders exercised their liquidation preference, and also participate in the remaining proceeds distributed pro rata, they would receive an amount equal to three times their invested capital.
Furthering the example, assume the company sold for $2,750,000. In this scenario, the VC would take their $500,000 liquidation preference, then they would start to participate in the remaining amount pro rata. However, the VC has participation rights that are capped at 3 times their invested capital, so they max out at $1,500,000 in distributions, and then you get your $1,250,000 distribution after their payout.