Capped participating preferreds: introduction

On a few VentureSouth investments over this fall, we led the round (as we like to do) and agreed a term sheet that included a capped participating preference.

As we have syndicated those investments with other angel investors and groups around the southeast, this term has caused some confusion and questions. So here is an attempt to explain the concepts and math around capped participating preferred in a quick series of posts.

First, background. For those new to angel investment structures, head over to our posts on preferred equity, 1x liquidation preferences, and participating preferred. The rest of this current series will make no sense without those basics.

To summarize those introductory posts:

  • Angels invest in preferred equity, a separate class of stock that has some extra rights.

  • One right is that when the company is acquired we get a “liquidation preference”: if there are limited proceeds for shareholders, we get all our money back before the common stockholders (the founders) see money from the sale.

  • A participating liquidation preference means we get our money back first AND we can convert our preferred equity to common to share proportionally in any remaining proceeds from the sale.

So, what is this capped participating preferred? A capped participating preferred means an investor has a liquidation preference that is participating (so we get our money back first AND convert to share proportionally in any remaining returns) BUT that the “participating” is capped at a certain amount.

On first read, what this means is not very clear. But we can tell you definitely what it does NOT mean. If you read nothing else in this series, read this: to be absolutely clear, this does NOT mean our total upside is capped in any way.

It would be idiotic to limit potential upside on an early-stage equity investment. They are risky and fail often, so any investment only makes sense if has a chance of generating a big return. Our base target is a 10x return in 5 years. If you cap the upside, there is obviously no chance of reaching those big returns.

What capped participating preferred actually means is:

  1. Ifthere are few proceeds, we have a 1x liquidation preference to get our money back.

  2. If there are enormous proceeds, we can convert to proportional ownership and take our share of those enormous proceeds.

  3. If we are somewhere in the middle, we need to figure out whether to take the participating preferred (which is capped) or convert to common (which is not capped). We have to decide what makes us the most money.

Deciding on #1 and #2 is easy. Deciding what happens on #3 requires a spreadsheet…