The Double Dip – Participating Pref

When investors put money in your company they usually do so through preferred shares (vs. the common shares you have as a founder).  The preferential features of those shares usually centre around the order in which money is distributed on exit. Investors will have a choice to either get their cost (or some multiple of it back) before common shareholders get any money or convert their prefs to common and get their % of the whole sale price. This is called a “liquidation preference”.

In modest exit prices you will almost always see investors exercise their liquidation preference. On the big home runs, they convert to common and share proportionately in the win.

One particularly onerous flavour of preferred share is the “participating” pref or double dip. With this beauty, investors can exercise their liquidation preference AND get their proportionate share of whatever is left over.  Here’s an example:

Capital raised: $ 10M

Ownership of investors: 40%

Exit price: $ 30M

In this scenario, if your investors convert to common, they would get $12m (40% of $30M). This is barely above a return of capital. Not the worst outcome for them, but not great. If however, they had participating prefs then they would get $18M ($10M cost + $8M – 40% of $20M). So, even though they own 40% of the company they would get 60% of the sale price. The situation is even worse if their is a multiple liquidation pref (i.e. >1x cost + participation in whatever is left).

So, how common place are participating pref shares? According to Fenwick & West, a leading venture law firm 35% of VC rounds had some form of participation in Q2 2010.

In my experience the “cuteness” of a term sheet is tied to the pre-money valuation. i.e. at lower valuations you see clean term sheets. 1x liquidation pref, no dividends, no participation. As valuation goes above an investor’s comfort level these terms creep in.

I can tell you I have never agreed to participation. But it does happen. I have heard of caps being put on the participation. At the end of the day, you need to play with some scenarios to see if it makes sense to have participation, put a cap on it or try and make it go away even if that means a slight decrease in pre-money.

This is especially important if it’s a first round financing, since whatever you give the early investors later investors will ask for.