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Preferred convertible stock includes two key features that skew the exit returns in the investor’s favour—liquidation preference and dividends.

Liquidation preference

The liquidation preference associated with the preferred convertible stock establishes how the proceeds will be divided when the company is liquidated, typically through a trade sale or acquisition. Two elements determine a stock’s liquidation preference—preference and participation.

Preference is related to the series of shares

For example, Preferred Series B shares tend to be senior to Preferred Series A shares, which are senior to common shares. The following language is common:

In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).

The usual preference is one times (1x) the original purchase price; in challenging economic times when investors are scarce, the preference may be higher.

Participation

There are three types of participation features—non-participating, fully participating and capped participation.

Non-participating preferred stock

Non-participating preferred stock will not share in the liquidation proceeds on a pro rata basis with common stock after payment of the liquidation preference. The provision is similar to the language above. If the proceeds are sufficient, then the holders of the preferred stock will voluntarily convert their preferred stock to common stock to maximize their share of the proceeds.

Fully participating stock

Fully participating stock will share in the liquidation proceeds on a pro rata basis with common stock after payment of the liquidation preference. The provision commonly reads as follows:

After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.

Capped participation

Capped participation indicates that the stock will share in the liquidation proceeds on a pro rata basis until a certain multiple return is reached. The provision commonly reads as follows:

After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis, provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.

Example: Liquidation preference

The following example demonstrates what this means for founders and management and the investors under three different scenarios.

Note: For the sake of simplicity, dividends have been excluded from this example and we assume only one series of preferred shares.

Liquidation preference—example
Amount your company is sold for $50 $50 $50 $50
Amount invested by investors for Series A Preferred Shares $20 $20 $20 $20
Investors ownership (Series A Preferred Shares) 50% 50% 50% 50%
Founders and management ownership (ESOP and Common) 50% 50% 50% 50%
Liquidation preference (x times) 1 1 2 2
Participation (Non-Participating (NP), Full or Capped) NP Full Full Capped
Participation cap n/a n/a n/a $41
Liquidation preference to Series A Preferred Shareholders n/a $20 $40 $40
Amount remaining for participation n/a $30 $10 $10
Participation proceeds to Series A Preferred Shareholders n/a $15 $5 $-
Total $ proceeds to Series A Preferred Shareholders $25 $35 $45 $40
Total $ proceeds to Common Shareholders $25 $15 $5 $10

From this example, you can clearly see how the different preference and participation terms can determine how the proceeds from exit are allocated. In the case of non-participating preferred shares, since the liquidation preference of 1x would yield $20 million in proceeds to the preferred shareholder, they then elect to convert to common shares and share pro-ratably in the exit proceeds. In the case of the full and capped participation, you’ll also note that even though the common shareholders own 50% of the company, they did not get 50% of the proceeds at this exit value.

Dividends

Preferred shares will often have a dividend, usually from 5% to 10% per year. These dividends tend to begin accruing at the close of the financing and can amount to a significant percentage of the original investment if the shares are outstanding for several years. Investors will have the right to be paid the dividends as part of the liquidation preference on exit proceeds.

What you should know about liquidation preference and dividends

There are a few ways to receive a higher percentage of the proceeds at exit:

  • Negotiate non-participating preferred shares, particularly in early rounds.
  • Cap the participation feature to get more of the proceeds.
  • Understand the market for liquidation preference and dividends. Deal terms change and you could have a higher participation or higher dividend rate than comparable deals closing at the same time. Your legal counsel and advisors can guide you on this point.

When you raise one or more senior rounds of financing, the follow-on investors in the class with seniority will stack their preference on top of each other—for example, Series B receives its preference before Series A.

Investors do not want to strip management of a return. They want to achieve a balance between protecting their downside, maximizing their potential return, and ensuring that management is fully engaged and motivated to make the venture a success. If the venture is extremely successful, all shareholders will be substantially rewarded. Investors also want to ensure participation of all shareholders in the proceeds if a reasonably good outcome is achieved.


Summary: Preferred convertible stock includes two key features that skew exit returns in the investor’s favour: liquidation preference (sets how proceeds will be divided when a company is liquidated) and dividends (ranges from 5% to 10% per year, paid to investors as part of the liquidation preference on exit proceeds).


References

Berkery, D. (2008). Raising Venture Capital for the Serious Entrepreneur. New York: McGraw-Hill.
Cardis, J., et al. (2001). Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and Practitioners. Toronto: John Wiley & Sons.
Houston, T., Johnson, A.,& Smith, E. (2006, September 15). Technology Startups: A Practical Legal Guide for Founders, Executives and Investors. Retrieved April 9, 2009, from Fraser Milner Casgrain website at http://www.techstartupcenter.com/