What is a cap on a participating preferred liquidation preference?
June 18, 2007
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.
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Would you kindly elaborate on how the preferred can obtain their preference (i.e. 2X or 3x) in liquidation event, and still convert to receive the common consideration thereafter (if available)? Aren’t the preferred holders faced with an either or election at the time of the liquidation event?
Thanks.
For a non-participating preferred or a participating preferred with a cap, there will be a transaction value where the preferred stock should convert to common stock.
For a participating preferred without a cap, there is never a need for the preferred to convert (as the participating preferred receives a preference, then participates with the common).
How you draft a provision that allows the series A to get their initial investment returned plus a certain annual return per year (percentage is not set yet) then the liquidation flips over to give 80% to the common shares and 20% to series A. Would this be a preferred cap provision?
@ Dan. This is not a standard provision. Guaranteeing a certain percentage return each year would be done by including a “cumulative” dividend (that would be paid upon a liquidation event — meaning a change of control). Having it turn into a fixed 80%/20% is extremely unusual and would require customization of the liquidation preference or the auto-conversion feature. Perhaps the easiest way to accomplish the economics would be to have an automatic conversion upon a change of control — so that the preferred converted into whatever number of shares of common in order to reach the desired economics — or a similar feature that ties the liquidation preference to the “as-converted” to common number of shares pursuant to the desired economics.
In the case of participating preferred with a cap, if there are multiple investors in a series (ex series B) and they chose to participate until the cap, do all the investors keep participating until everyone hits the cap or does an investor stop participating as soon he hits his specific cap? In other words if there are 3 investors (X,Y,Z) in a series B round and X hits its cap, then will X continue to participate with Y & Z, until Y & Z hit their respective caps?
I am looking at a term sheet with the above scenario and need some urgent input. So any quick input is much appreciated.
You should chat with your attorneys.
All holders of a particular Series (i.e. Series B) are treated the same. So each holder of Series B would hit their cap at the same time.
The question that you are probably asking is what happens if the Series A has a cap and the Series B has a cap? Often, the Series A hits their cap first (before the Series B), so after a certain sale of company valuation, the Series A should convert to common instead of taking the liquidation preference. At a certain higher value, the Series B will also be better off converting to common.
yokum,
Like you mentioned Series A does hits its cap before Series B. But within series B, since different investors have different caps ( based on their purchase price ), they would theoretically/mathematically hit their caps at different valuations.This most probably happens because of the excess amount left over after Series A hits its cap. So, it is possible that investor X hits its cap before investor Y. Hence, this gives rise to a scenario when all series B investors don’t hit their cap at the same time. So, the question then is does X participate with Y until Y hits its cap.
I will check with my team, but thanks for your input.
This is what keeps people like me in business … your fundamental understanding of how the cap works is incorrect.
The cap is done on a per share basis, not on a per investor basis. Thus, even if different investors in the Series B invest different amounts of money, each share of Series B will hit the cap at the same sale of company valuation. It’s just that some investors will own more shares and some investors will own less shares of Series B.
Thanks for the clarification. Appreciate your time and patience.