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.

Comments

  • Mike

    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.

  • http://www.startupcompanylawyer.com Yokum

    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).

  • Dan

    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?

  • http://www.startupcompanylawyer.com Yokum

    @ 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.

  • md

    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.

  • http://www.startupcompanylawyer.com Yokum

    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.

  • md

    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.

  • http://www.startupcompanylawyer.com Yokum

    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.

  • md

    Thanks for the clarification. Appreciate your time and patience.

  • john

    Yokum,
    If an investor is looking initially for a 50% interest in a company on the initial round (after founders investment), would a participating preferred with a cap be a way to bring both sides to an agreement. the investor initially gains the equity he requires, but upon a significant liquidation event i.e. 5M investment yields an event of 100M in 5 years, would a 4x or 5x be a reasonable cap?

  • http://www.startupcompanylawyer.com Yokum

    @John – don't understand the question. A participating preferred with a cap is a middle ground between non-participating and fully-participating, so it may be considered a compromise.

  • Guest

    I am trying to understand how participating preferred works. Our company received series A funding $5M with 3x participating preferred option. Company has received an acquisition offer. Say we have 11M shares and offer is $20M, how does the common stock holders get their money after the investors get their money.

  • william

    hello. if currently have 100,000 shares at a nominal value of £1 per share and represents 100% ownership, and want to give a way 4% of the comapny for £4000 at £1 per share, on the face of it creating 4000 shares makes sense but that actually is 3.8%. and 4167 shares is 4% leaving me with 96%. This means that the investor gets 4167 shares and not 4000, but if they paid £4000 and not £4167, then who pays for extra 167 shares.

    I know its confusing, but comments are welcome., thanks

  • Guest

    I'm working on exit scenarios with various capital structures for different companies and was wondering if there is an easy formula to use in identifying the liquidation waterfall (i.e. at what point a particular class of participating preferred would convert to common). It seems, with each different company, I have to analyze this in great depth, but was wondering if there was a shortcut formula to quickly identify the timing of conversions…..any suggestions?

  • http://www.startupcompanylawyer.com Yokum

    No particular shortcut. You have to read the certificate of incorporation and create a model.