Before we unleash the spreadsheet, though, let’s cover where the idea of capped participating preferreds comes from.
The capped participating preference is not a VentureSouth innovation; it’s not even particularly novel or unusual. In fact, it’s an explicit option in the NVCA model documents, in the Term Sheet – Liquidation Preference section, Alternative #3, on page 3. The language there (in the August 2020 version) is:
[Alternative 3 (cap on Preferred Stock participation rights): First pay [___ times] the Original Purchase Price [plus accrued and declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).]
Translating from legalese: preferred (investor) shareholders (called Series A Preferred in this example) get 1x back, then anything else is split in proportion to share ownership until you reach a ___x return.
Now you’re probably confused. This is pretty clear (for legalese) that the Series A Preferred participates only up to ___x the purchase price; it doesn’t say what happens if there are still proceeds beyond that maximum. Isn’t this capping the upside, which we said last post was idiotic?
Well, yes, but… Later on in the Term Sheet, under Optional Conversion, you see that the preferred shareholders can convert to common stock any time they want to. The language is:
The Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described below under “Anti-dilution Provisions.”
You need to take these two quoted sections together. If we are getting our return “capped” under Alternative 3’s terms, we simply convert to common. We then own our share of the common stock and split the proceeds proportionally. Not capped now!
In practice, the Term Sheet translates into the company’s Certificate of Incorporation, which solves this apparent cap by being clearer that the Series A shareholders get the as-converted amount if this is higher than the “capped participating” amount (see page 9, section 2.2, and the extra sentences in footnote 17).