What is “participation”?
One last complication about liquidation preferences. A liquidation preference may, or may not, be “participating.”
What does this mean?
If the preference is participating, the preferred shareholder takes its preferred return (the 1x liquidation preference) AND then converts its shares into common stock and splits the rest of the return in proportion to how much it owns.
If the preference is not participating, the preferred shareholder can EITHER take the preferred return OR convert its shares into common stock and split the proceeds in proportion.
An example would be helpful.
Let’s say a company is sold for $30 million and VentureSouth’s angels had a 1x participating liquidation preference from $500,000 of preferred stock we invested to buy 1/6th of the company.
At the liquidation event, $30 million needs to be distributed.
(A) If the preferred return is participating, we get 1x (our initial $500,000) back, which leaves $29.5M in the pot. We then convert our shares into common stock, then split the pot 1/6th to us and 5/6ths to the other shareholders.
(B) If the return is not participating, we can either (i) take our 1x preference ($500,000) or (ii) we can convert into common stock for 1/6th of the company and split it. As 1/6th of $30 million is much more than $500,000, we obviously do (ii) – convert and take our $5 million.
Here's the calculation
Is participation standard?
It’s a touch “investor-friendly,” but it is pretty common. Around half of our investments have a participating liquidation preference.
How can you justify “having your cake and eating it”?
Well, the smaller the exit, the larger the relative impact of the participation. (In the example above, it was an 8% boost. If the exit had been only $10 million it would have been a 25% boost.) Or you could say: the more the entrepreneur fails to hit the plan he or she promised investors, the more protection the participation provides to investors.