Why do preferred stockholders have odd economic incentives upon a sale of company when they have non-participating preferred stock or particpating preferred stock with a cap?

December 20, 2008

Even savvy investors often don’t understand the subtle nuances on economic incentives that result from non-participating preferred stock or participating preferred stock with a cap in the event of a sale of company.

Assume a simple cap table of:

10,000,000 shares of common stock

10,000,000 shares of Series A preferred stock

Also assume that the Series A preferred stock has a $1.00/share liquidation preference and is non-participating.

If the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.

If the company is sold for $10M to $20M, the holders of Series A would still receive $1.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common.  For example, if the merger consideration is $15M, then the Series A would receive $1.00/share and the common would receive $0.50/share.  Thus, the holders of Series A are indifferent between sale prices from $10M to $20M, which may lead to odd economic incentives.  Hypothetically, a venture capital fund holder of Series A might not want a company to argue hard over merger valuation with an acquiror if there is no marginal benefit to the fund and there is a risk that the deal may fall apart.

If the company is sold for over $20M, the holders of Series A would convert to common (assuming that they are economically rational).  For example, if the merger consideration is $30M, then the common would receive $1.50/share (assuming all Series A converted).  Of course, if some holders of Series A did not act in their optimal economic interest and convert, then the merger proceeds available to the common would increase and the common would receive greater than $1.50/share.

Similarly, if the Series A is participating with a cap, there will be a range of merger consideration values where the holders of Series A will be indifferent because the cap has been met, but it still does not make economic sense for the Series A to convert.

In the same example, assume that the Series A has a $1.00/share liquidation preference and is participating with a 3X cap.

Like the non-participating preferred, if the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.

For merger consideration greater than $10M but less than $50M, the Series A participates with the common on the amount over $10M.  For example, if the merger consideration is $20M, the holders of Series A would receive $1.50/share, or an aggregate of $15M (which represents the $10M liquidation preference and $5M of participation with the common), and the holders of common would receive $0.50/share, or an aggregate of $5M.

If merger consideration is $50M, the holders of Series A would receive $3.00/share, or an aggregate of $30M (which represents the $10M liquidation preference and $20M of participation with the common), and the holders of common would receive $2.00/share, or an aggregate of $20M.  At $50M, the Series A hits the 3x cap on participation by receiving $3.00/share.

If the company is sold for $50M to $60M, the holders of Series A would still receive $3.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common.  For example, if the merger consideration is $55M, then the Series A would receive $3.00/share and the common would receive $2.50/share.  Thus, the holders of Series A are indifferent between sale prices from $50M to $60M, which may lead to the same odd economic incentives as the non-participating preferred stock, albeit at higher transaction values.

If the company is sold for over $60M, the holders of Series A would convert to common (assuming that they are economically rational).  For example, if the merger consideration is $60M, then the common would receive $3.00/share (assuming all Series A converted).

Please see the liquidation preference spreadsheet and program some examples if you want to proof this yourself.

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