Participation Preferred:

 

The liquidation preference, defines a mechanism for recovery of the original investment (or it’s multiple). The participation preferred terms are an aspect of the greater liquidation preference terms and they define how the remainder of the money, is distributed after the execution of the actual liquidation preference. There are three basic varieties of participation: Full Participation, Capped Participation, No Participation.

 

The full participation terms state that after the payment of the liquidation preference to the investors, the remainder of the proceeds from a liquidity event shall be distributed based on ownership on an as-converted basis to common stock.

 

Here is an example: XYZ Inc saw a total Series A investment of $5,000,000 for a 10% ownership in the company. The company was later sold for $12,000,000. Series A investment had a 1x liquidation preference term & full participation. In this case the Series A investors first receive $5,000,000 before the remainder $7,000,000 is distributed among the common and preferred stock (as-converted basis). Series A investor receives a total of $5,700,000 and the common stock receives $6,300,000. The $6,300,000 payout despite the 90% ownership and scenarios like these is what surprises company founders at exits. I shall create more scenarios as we progress with explaining liquidation preference and participation preferred.

 

Capped Participation and No Participation terms are an option to control double dipping by preferred stock holders at exit.

 

Capped participation terms state that once the investors receive their liquidation preference, they have an option to receive a return up to a capped amount which is a multiple of the original investment and no more(including the liquidation preference), OR the investor foregoes of both the liquidation preference and participation terms and converts to common stock on an as-converted basis for a proportional distribution of money from the liquidity event.

 

Let’s modify the previous scenario. XYZ Inc received a $5,000,000 Series A investment in return for 10% ownership with liquidation preference and 2X capped participation. XYZ Inc was sold for $12,000,000. The investor would evaluate the outcomes with and without participation preferred. With executing on participation preferred, the investor would receive $10,000,000. Without participation preferred the investor would only receive $1,200,000. In this scenario, the distribution would be $10,000,000 to Series A and $2,000,000 to founders. If XYZ Inc was sold for any value greater than $100,000,000 the investor would have opted to not execute on participation preferred terms and just convert all preferred stock to common during the liquidity event.

 

No Participation terms indicate that the preferred stock does not participate; meaning, in a liquidity event, the holders of preferred stock have the option of either executing their liquidation preference and no more, OR convert to common stock in an as-converted basis for a proportional distribution of money from the liquidity event.

 

Let us modify the last scenario: same investment terms, except, Series A is not participation. In case of the exit the Series A investor has to make a choice between a $5,000,000 payout if the liquidation preference is executed, OR $1,200,000 if the Series A is converted to common stock prior to exit. In this scenario, the investor would prefer $5,000,000 while the founders receive $7,000,000. If XYZ Inc was sold for any value greater than $50,000,000 the investor would have opted to not execute on their liquidation preference.

 

The graphs below shows effect of the value of the liquidity event on the return on investment (ROI) on a Series A investment of $5,000,000 for a 10%, 40% & 80% ownership in XYZ Inc under full participation, capped participation [2x] and no participation scenarios with actual liquidity preference of 1x. As you can see, participation preferred parameters have a greater effect when the relative return on investment is low. For a higher liquidity event, the relative influence of participation preferred is insignificant. Full participation will continue to provide a slightly higher return in comparison to other participation preferred options at higher liquidity event values, but this difference is a fixed dollar amount. Also to note the liquidation and participation preferences playing a key role in protecting investments when the relative investor ownership is low (look at 10% ownership examples.

 

Moving the cursor over a graph will change the view to focus on the relationship between liquidity events and participation preferences at lower ROIs.