Capped participating preferreds: the real impact 2: the grey zone

Following from the last post, there was a range of fairly attractive outcomes where the capped participation had an impact: let’s review the results from the grey zone.

Grey zone: In the (C) grey zone, we have a moderately good result, but one where the capped participation has a mixed impact. Regardless of the exit amount in this range, our choices are:

• (Scenario 1) With no participation, we make the same decision as the green zone – we have decide whether to take our 1x liquidation preference (\$2M) OR convert into common and take our 25% of the \$33M or more (\$8.25M). Obviously, we take the higher number, so convert.

• (Scenario 2) With full participation, again there no choice to make: we get our \$2M liquidation preference AND 25% of the remaining \$22M.

• (Scenario 3) With capped participation, we still have to decide whether to take our capped participation (the participating preference up 4x * \$2M = \$8M) OR convert to take 25% of the exit value. The decision is the same across all this range: we take the capped participation, as that is always higher than converting and taking 25% of the proceeds.

But look what happened there in columns E and H:

• In Column E, our capped participation is juicing our returns nicely, increasing us from \$2.5M in the non-participating scenario to \$4M in the capped participating. That’s why we included this term, to help improve our outcome in scenarios where the entrepreneur didn’t really deliver on the plan.

• In Column H, though, we are getting maxed out at \$8M of proceeds in that “window” of exits between \$26M and \$32M. In column H, the cap cost us \$1.25M compared to the fully participating; but it’s also \$0.25M better than had we taken a non-participating liquidation preference. This is giving the entrepreneur some “catch up” for delivering pretty well on the plan.