What does the capped participation preference mean in practice?
Time for the promised spreadsheet: this sheet lays out the returns for preferred shareholders in (1) a non-participating preference, (2) a (fully) participating preference, and (3) a capped participation preference in various exit outcomes in an example transaction.
The basic investment is:
VentureSouth angels are leading a $2M preferred equity round to purchase 25% of a company. The preferred has a 1x liquidation preference.
VentureSouth offered a participating preference (Scenario 2); the company said no, we would like it to be non-participating (Scenario 1); and we compromised at a capped participating preference where the “participating” was capped at 4x (Scenario 3).
(We’re simplifying a lot here, of course: no fees, no later rounds of equity, no convertible notes messing everything up, no option pools, etc…)
The columns across show different exit valuations and the proceeds for preferred shareholders.
Orange Zone: In the (A) orange zone, we have a fire sale – selling the company for $1M or $2M in columns C and D. VentureSouth has a 1x liquidation preference on our $2M invested; we are therefore entitled to the first $2M of proceeds, so we get 100% of the capital returned here.
(We could consider converting our preferred to common shares, but if we did so we would get 25% of $1M, so less than keeping our preference. Fairly easy decision!)
The liquidation preference is critical here, but the “participation” doesn’t matter – because there are no proceeds above $2M to participate in.
Green Zone: In the (B) green zone, we have an excellent result, selling the company for $33M or more. In this scenario, we have to make different choices:
(Scenario 1) With no participation, we have to decide whether to take our 1x liquidation preference ($2M) OR convert into common and take our 25% of the $33M+ ($8.25M+). Obviously, we take the higher number ($8.25M+) by converting.
(Scenario 2) With a (full) participation, there are no choices to make this time: we are entitled to our $2M liquidation preference AND 25% of the remaining $31M+.
(Scenario 3) With a capped participation, we have to decide whether to take our capped participation (4x * $2M = $8M) OR convert to take 25% of $33M. This is a closer call but still obvious – we take the higher, which is to convert, in cell I26.
Note that most importantly this is not capping our upside: in the $100M exit, we are receiving $25M of proceeds, the same as the non-participating scenario.
It does, though, show the real cost of the compromise in the deal terms. Had we insisted on the fully participating scenario 2, we would have an extra $1.5M of proceeds now.
We’ll tackle the returns in the grey zone in the next post.