Get expert advice on every topic you need as a small business owner, from the ideation stage to your eventual exit. Our articles, quick tips, infographics and how-to guides can offer entrepreneurs the most up-to-date information they need to flourish.
February 3, 2015 | 3-minute read (608 words)
This post by Ian Engstrand first appeared on Founders Workbench.
From time to time on Founders Workbench we give a brief primer on common terms and issues in venture financings. Today, we’re tackling participating versus non-participating preferred stock, a fundamental economic term in VC deals that goes to the heart of the business agreement between investors and management in connection with a sale of the company.
Generally, upon the sale of a company, a holder of either participating or non-participating preferred stock is entitled to a preferential return (typically this is the amount of investor’s initial investment, often plus an accruing dividend), before any payment is made to the holders of common stock (i.e., management).
Participating versus non-participating: what's the difference?
The difference between the two types of preferred stock is that participating preferred stock, after receipt of its preferential return, also shares with the common stock (on an as-converted to common stock basis) in any remaining available deal proceeds, while non-participating preferred stock does not. Put another way, participating preferred stock entitles the holder to its investment amount back (plus an accrued dividend, if applicable) first and its pro rata “common upside” in the company, while nonparticipating preferred stock entitles the holder to the GREATER OF its investment amount back (plus an accrued dividend, if applicable) OR its pro rata “common upside” in the company.
If a company is sold or liquidated at a price that is less than the aggregate investment amount of the preferred, the distinction is irrelevant, as both securities give the investors “downside protection” with no proceeds being available for distribution to the common shareholders. However, in a moderate or successful outcome, the distinction can have a significant impact on the allocation of deal proceeds between the investors and the management team.
For example, Company A has one series of non-participating preferred stock with a liquidation preference of $6 million representing 50% of the capital stock of Company A. If Company A were to be sold for $10 million, the investors would receive $6 million (as the $6 million investment amount is greater than the preferred’s 50% share of the $10 million sale proceeds) and the remaining $4 million of proceeds would be distributed to management.
Company B also has one series of preferred stock with a liquidation preference of $6 million representing 50% of the capital stock of Company B, but its preferred stock is participating. Upon the same $10 million sale event, the investors would receive $8 million (the $6 million liquidation preference plus 50% of residual $4 million of sale proceeds) and the remaining $2 million of the proceeds would be distributed to management. Thus, in the same $10 million sale, the difference in terms between participating versus non-participating preferred resulted in a $2 million shift in economics away from management to the investors, which represents one-half of the return that management would have received had the preferred stock been structured as non-participating.
Ian Engstrand is a Partner in Goodwin Procter's Technology Companies and M&A/Corporate Governance Practices, where he represents companies in a diverse range of industries including: digital media, software, Internet, search, mobile, security and enterprise services, medical technology and clean tech. His areas of expertise include company formations, equity financings, mergers and acquisitions, capital markets transactions, and corporate governance.
Questions about funding vehicles or strategies? Tell us in the comments section below or contact us at Early Growth Financial Services for a free 30-minute financial consultation.
Liked this post? Join our mailing list to get our posts on startups sent directly to your inbox.
Related Posts:
Accounting
Finance
Learn how we can put more time back in your day.
