Archives for June 2007

Wilson Sonsini Goodrich & Rosati publishes a report on private company financing trends. According to VentureOne, WSGR represents more companies that receive venture financing than any other law firm in the United States. In 2007, WSGR represented companies in over 500 venture equity and debt financings, which was 20.6% market share among U.S. law firms.

Various issues of the report cover valuation trends, amounts raised by series, up rounds vs. down rounds, liquidation preferences, pay-to-play, dividends, anti-dilution and redemption rights.  Authors of articles include WSGR attorneys, venture capitalists, accountants and D&O specialists.

WSGR Entrepreneurs Report Fall 2008 – Printable PDF or HTML version

WSGR Entrepreneurs Report Summer 2008 – Printable PDF or HTML version

WSGR Entrepreneurs Report Spring 2008 – Printable PDF

WSGR Entrepreneurs Report Winter 2007 – Printable PDF

WSGR Entrepreneurs Report Fall 2007 – Printable PDF

WSGR Entrepreneurs Report Summer 2007 – Printable PDF

In a Series A financing, the priority of the liquidation preference vis a vis other series of preferred is not relevant because there are no other series of preferred stock. However, in a Series B financing, the new investors may request that their liquidation preference be senior to the Series A.  In other words, the Series B gets paid before the Series A. The Series A investors may argue that the priority of the Series B liquidation preference should be the same, or “pari passu,” with the Series A.  Founders and companies should be very careful when negotiating liquidation preferences (and any term) at the Series A stage.  When the Series B financing occurs, the Series B will demand at least the same level and priority of rights as the Series A.  Although a 2x preference may not seem that onerous while raising $2 million of Series A, a 2x preference on $20 million will significantly affect the holders of common stock.

A cap on participation limits the amount received by the preferred stock to a fixed amount. The cap is typically fixed as a multiple of the original investment, such as 2x or 3x. Once holders of preferred stock have received the cap amount, they will stop participating in distributions with the common stock. Thereafter, holders of common stock receive all proceeds until holders of common stock have received the same amount per share as the preferred. After that transaction value, holders of preferred stock will be economically incentivized to convert to common stock in order to receive maximum value. Unfortunately, this math is not particularly easy to understand.

Imposing a cap on participation allows the holders of preferred stock to receive a return on their investment without having to convert their holdings to common stock, but leaves the incentive to convert in place where the sale or liquidation occurs at a high valuation.

There are two basic types of liquidation preferences: “non-participating” and “participating.”

“Non-participating” preferred typically receives an amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event.  Holders of common stock then receive the remaining assets.  If holders of common stock would receive more per share than holders of preferred stock upon a sale or liquidation (typically where the company is being sold at a high valuation), then holders of preferred stock should convert their shares into common stock and give up their preference in exchange for the right to share pro rata in the total liquidation proceeds. Non-participating preferred stock is favored by holders of common stock (i.e. founders, management and employees) because the liquidation preference will become meaningless after a certain transaction value.

Please note that each series of preferred stock may be economically incentivized to convert to common stock at different transaction values due to different preference amounts per share for the different series.  This necessitates creating complex spreadsheets to model what happens upon a sale of company at different transaction values.  The most sophisticated spreadsheets will also take into account whether options and warrants are in the money at certain transaction values, which will affect whether or not they are exercised, which will then affect the price per share.  These circular formulas are best left to CFOs with strong math skills or attorneys that deal with these spreadsheets all the time.

“Participating” preferred also typically receives an amount equal to the initial investment plus accrued and unpaid dividends upon a liquidation event. However, participating preferred then participates on an “as converted to common stock” basis with the common stock in the distribution of the remaining assets.

Participating preferred stock is favored by investors because they will receive a preferential return over both low and high exit transaction values.  An argument in favor of participating preferred stock is that if a company is sold shortly after the investment, the founders may receive a significant return on their investment (since they have typically paid a much lower price than holders of preferred stock) while the holders of preferred stock may receive little or no return on their investment, particularly where the liquidation preference is 1x.  A counter-argument is that if a company is sold for a high price, the holders of preferred stock have no incentive to convert their shares into common stock and, as a result, are able to “double-dip” into the proceeds by receiving both the preference amount and the participation proceeds.  Thus, one compromise is a participating preferred with a cap, which will be covered in the next post.

The amount of the liquidation preference is a function of the risk of the investment.  In typical venture financings, the amount of the liquidation preference is the amount invested by the investors.  In other words, if the Series A was issued for $1.00/share, a holder of one share of Series A receives $1.00 prior to any distributions to holders of common stock.  This is referred to as a 1x preference.  During the 2001 to 2003 time period, liquidation preferences of multiples greater than the purchase price (expressed as 2x, 3x, etc.) were not unusual.  Liquidation preferences of greater than 1x may be negotiated when a company has had difficultly raising funds.

Aggressive liquidation preferences can wipe out the interests of holders of common stock absent a “home run.”  If a company raises a lot of money with liquidation preferences greater than 1x, then the amount that the company must be sold for in order for the holders of common stock to receive a return may be quite high.  This is sometimes not fully understood by founders and management.

The most important economic provision in a venture financing other than valuation is probably the liquidation preference.  One of the basic features of preferred stock is providing for an ordering of returns to different classes and series of stockholders upon significant company events. The liquidation preference provision is the principal mechanism to allow preferred stock to receive a priority return upon these events.

The triggering events for a liquidation preference payment typically include both a winding up of the company (e.g. a true liquidation) and a sale of the company through a merger, stock sale, sale of assets or other acquisition of the company (also known as a “deemed liquidation”).  The liquidation preference is meaningless if the company goes public, as the preferred stock issued to investors converts to common stock and the liquidation preference goes away.

The structuring of liquidation preferences is critical and is not always fully appreciated by companies and founders as they set a precedent for future financing rounds, which have significant economic effects.  The elements of the preferences can be varied to create different incentives and returns. The key variables are: (1) the amount of the initial preference to be paid to preferred stockholders, (2) the priority of payments among different classes (preferred versus common) and series (series A versus series B) of stock and (3) the extent, if any, of participation of the preferred stock with the common stockholders in the distribution of the remaining assets.

The liquidation preference is one of the features of preferred stock that companies can point to as a means of justifying the grant of stock options with a “fair market value” exercise price that is lower than the purchase price for the preferred shares in the latest round of financing. The liquidation preference justifies a high price for the preferred stock, such as $1.00/share, while maintaining a low common stock fair market value, such as $0.10/share.  This is good for the company as employees view the discount as immediate “paper” profit.