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.

I have never encountered a private venture-backed startup company that paid a dividend, except in connection with a spinoff or other distribution to stockholders that might trigger the dividend preference of preferred stock.  Most startup companies do not generate enough cash to pay dividends and investors typically do not expect actual dividend payments.

Dividends are typically only paid when and if declared by the board.  If a company pays dividends, then holders of preferred stock receive dividends before dividends are paid to holders of common stock.  Typically, dividend rates range from 7% to 12%, varying somewhat to match interest rates.  If dividends are only paid at the discretion of the board, then this percentage is not very meaningful.

In some financings, the investors may require that dividends accrue and cumulate whether or not declared by the board.  Cumulative dividends are more prevalent in East Coast venture financings than West Coast venture financings.  According to WSGR data, non-cumulative dividends are much more common than cumulative dividends.

If dividends cumulate, companies will want all previously accrued but unpaid dividends to be waived upon the automatic conversion of the preferred stock. In contrast, investors will want the unpaid dividends to be paid or to be converted into common stock upon conversion or liquidation.

Companies should be wary of dividends that cumulate because the effect on total returns can be significant in the case of investments that remain outstanding for several years. If dividends cumulate, unpaid accumulations will be added to the liquidation preference and may be added to the redemption price, if applicable. In addition, companies should realize that cumulative dividends are liabilities that generally appear on the company’s balance sheet, which may lower the company’s ability to borrow and affect solvency analysis.

Of course. Depending on the situation, additional closings can continue to be held for up to a fixed period of time (such as 30, 60, 90 or 120 days) after the first closing. The company may want the flexibility to hold additional closings at any time at the discretion of the board of directors. The investors in the first closing may require that the timing and identity of investors in an additional closing be approved by a majority (or super-majority) of investors in the first closing. If the investors in the first closing are represented on the board of directors, then one middle ground is that additional closings be unanimously approved by the board of directors. The issue on additional closings is whether it is fair for investors in a later closing to purchase at the same price as the investors in the first closing because the value of the company arguably should increase over time.

The formula is:

[Series A price per share] = [valuation] / [fully-diluted pre-money shares]

Obviously, there are two ways to affect the Series A price per share (and the resulting dilution to pre-Series A stockholders):  (1) change the valuation, or (2) change the number of fully-diluted pre-money shares.  Arguing for a change in valuation is probably difficult.  However, arguing for a different number of fully-diluted pre-money shares might be an easier way to affect the Series A price per share.

Fully-diluted pre-money shares typically includes (1) all outstanding common stock, (2) all outstanding preferred stock (if any, on a converted to common basis), (3) outstanding warrants, (4) outstanding options, (5) options reserved for future grant, and (6) any other convertible securities on an as converted to common basis.

Decreasing the size of the option pool is one way to increase the Series A price per share.  Series A investors want to make sure that there is a sufficient option pool for future hires, and that the dilution for the option pool is borne by pre-Series A stockholders. A company may argue that the size of the option pool does not need to be as large as requested by the Series A investors. Generally, the option pool needs to be large enough to hire necessary people through the next round of financing (or a time period such as 12 to 18 months if the company does not anticipate another round of financing). Please read the Venture Hacks article on the Option Pool Shuffle for more explanation.

In addition, there are some plausible arguments that shares issued upon conversion of a convertible note or warrants issued in connection with the convertible note prior to a Series A financing should not be counted in full-diluted pre-money shares.  Please read the comments to the Option Pool Shuffle article for more details.

Preferred stock generally has rights senior to common stock. Startup companies typically issue common stock to founders (and options to purchase common stock to employees) and preferred stock to investors. One reason for issuing preferred stock to investors is to preserve the ability of a company to issue options to purchase common stock at an exercise price at a significant discount from the preferred stock price. Before accounting and tax rules became more stringent on the valuation of common stock, companies generally used to value their preferred stock as ten times more valuable than common stock until the 12 to 18 month period before an IPO. In other words, if Series A preferred stock was sold for $1.00/share, an option to purchase common stock would have an exercise price of $0.10.

If a company issued common stock to investors, then the exercise price of options to purchase common stock would generally need to be the same price as the price to investors. In this scenario, employees may not believe that they are receiving the benefit of “sweat equity.” However, there are some companies, such as broadcast.com, co-founded by Mark Cuban, that completed all of their pre-IPO financings by selling common stock.

Another reason that investors purchase preferred stock is to receive rights, preferences and privileges senior to common stock. The most important economic right of preferred stock is the liquidation preference, or the ability to recover the investment (and more) upon a liquidation or sale of the company. Other important rights of the preferred stock include voting provisions and anti-dilution protection. I will cover these and other rights in future posts.