Growth5 Blog

Thursday, May 27, 2010

Bridging the Valuation Gap: Participating Preferred

Fred Wilson of Union Square Ventures recently posted about changing his position on the "double dip" of Participating Preferred Shares (mostly against it now). Although Wilson uses the Participating Preferred in certain circumstances these days, his post was an excellent reminder of how Participating Preferred can be a great compromise when you can't agree with an entrepreneur on valuation.

What are Participating Preferred Shares? Wilson offers this simple and easy to follow explanation:
"In a preferred stock, the investor gets the option of taking their money back in a sale or taking the share of the company they bought. I believe a preferred stock is critical in venture investing. However a participating preferred goes one step further. In a participating preferred, the investor gets their money back and then gets their ownership share of what is left.

Let's do a simple example. Let's say you invest $1mm for 10% of the business. And let's say the business is sold for $25mm. In a preferred (sometimes called a "straight preferred") you get the choice of getting your $1mm back or 10% of $25mm. You'll take the $2.5mm.

But if you own a participating preferred, you get your $1mm back and then you split the $24mm that is left with the founder. So you get $2.4mm of what is left and the founder gets $21.6mm. You end up getting $3.4mm with the participating preferred vs $2.5mm in the straight preferred."
Let's say that you are willing to invest $1mm into a company for 10 percent of the firm, but the entrepreneur won't budge from that same $1mm being worth only 5 percent of the company (the entrepreneur believes the firm is worth twice of what you do). If you can get the entrepreneur to agree to a Participating Preferred deal under the 5 percent terms, you will be protected if the company doesn't do as well on a sale as think entrepreneurs think they will.

You make the deal for the Participating Preferred Shares owning 5% of the company for a $1mm investment. The company later sells for $15mm.

Had you been able to negotiate the lower valuation / higher percentage (10 percent) back when you invested, you would have walked away from the sale with $1.5mm ($15mm x 10 percent).

Had you only negotiated Straight Preferred Shares (not Participating) at 5 percent, you would have walked away from the $15mm sale with $1mm as you would have had the choice of getting your $1mm back or taking $750k ($15mm x 5 percent). You would probably take the $1mm.

However, even though you agreed to a higher valuation / lower percentage (5 percent) the Participating Preferred Shares you negotiated would pay you back your original $1mm and then you would take 5 percent of the $14mm left over, or $700k for a total of $1.7mm, which is MORE than you would have made owning 10 percent of the company with no Participating Preferred Shares ($1.5mm). And more than the Straight Preferred at 5 percent ($1mm).

Participating Preferred Shares are a great bridge when you have a valuation gap. If the sale price exceeds every one's expectations, you aren't going to care that you didn't get your originally offered lower valuation price / higher percentage of the company.

It's when things don't turn out as well as planned that you can still show a modest return on your investment by using this vehicle. These type of shares work as they are intended if the entrepreneurs aren't able to follow through on their vision that they had based their higher valuation on. The entrepreneurs are making the $15mm sale based on the last investment round of your money closing at $20mm. But since you negotiated Participating Preferred Shares, you are basically cashing out as if you had invested at a $10mm valuation (your original intention) and sold at $15mm.

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