As we asked in the last post, are capped participating preferreds unusual?
Well, it is option #3 in the term sheet – people generally go with option 1 or 2! – and is slightly more complicated to explain to founders and syndicate partners – hence these posts. This extra difficulty makes it less popular than alternatives 1 and 2.
So why use it? Well, it’s a compromise. We will (usually) ask for a 1x participating liquidation preference; sometimes the founders have enough leverage or credibility to convince us to accept a 1x non-participating liquidation preference instead; and sometimes we have to find the middle ground.
(Both parties should also be wary about setting a precedent. Angels might like an unlimited participation now, but a further round (or five) of venture capital money is planned, angels might not like those bigger investors having a participating preference getting paid out first. So we might prefer a capped participation in the angel round. This is partly because a following VC fund should not care so much about it: the capped participation does not impact on the “enormous proceeds” scenario (#3 in the first post), which is generally the VC investment model, and so might even ignore it.)
Next in the series will look at what the actual impact of capped participation is.