On a few VentureSouth investments over this fall, we agreed a term sheet that included a capped participating preference.
As we have syndicated those investments with other angel investors and groups around the southeast, this term has caused some confusion and questions. So here is an attempt to explain the concepts and math around capped participating preferred.
First, background. For those new to angel investment structures, you need to know about preferred equity, 1x liquidation preferences, and participating preferred. The rest of this article will make no sense without those basics.
To summarize those basics:
· Angels invest in preferred equity, a separate class of stock that has some extra rights.
· One right is that when the company is acquired we get a “liquidation preference”: if there are limited proceeds for shareholders, we get all our money back before the common stockholders (the founders) see money from the sale.
· A participating liquidation preference means we get our money back first AND we can convert our preferred equity to common to share proportionally in any remaining proceeds from the sale.
So, what is this capped participating preferred? A capped participating preferred means an investor has a liquidation preference that is participating (so we get our money back first AND convert to share proportionally in any remaining returns) BUT that the “participating” is capped at a certain amount.
On first read, what this means is not very clear. But we can tell you definitely what it does NOT mean. If you read nothing else in this series, read this: to be absolutely clear, this does NOT mean our total upside is capped in any way.
It would be idiotic to limit potential upside on an early-stage equity investment. They are risky and fail often, so any investment only makes sense if has a chance of generating a big return. Our base target is a 10x return in 5 years. If you cap the upside, there is obviously no chance of reaching those big returns.
What capped participating preferred actually means is:
1. If there are few proceeds, we have a 1x liquidation preference to get our money back.
2. If there are enormous proceeds, we can convert to proportional ownership and take our share of those enormous proceeds.
3. If we are somewhere in the middle, we need to figure out whether to take the participating preferred (which is capped) or convert to common (which is not capped). We have to decide what makes us the most money.
Deciding on #1 and #2 is easy. Deciding what happens on #3 requires a spreadsheet…
Before we unleash the spreadsheet, though, let’s cover where does this idea come from?
Capped participating preferred is not a VentureSouth innovation; it’s not even particularly novel or unusual. In fact, it’s an explicit option in the NVCA model documents, in the Term Sheet — Liquidation Preference section, Alternative #3, on page 3. The language there (in the August 2020 version) is:
[Alternative 3 (cap on Preferred Stock participation rights): First pay [___ times] the Original Purchase Price [plus accrued and declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock pro rata on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price (including the amount paid pursuant to the preceding sentence).]
Translating from legalese: preferred (investor) shareholders (called Series A Preferred in this example) get 1x back, then anything else is split in proportion to share ownership until you reach a ___x return.
Now you’re probably confused. This is pretty clear (for legalese) that the Series A Preferred participates only up to ___x the purchase price; it doesn’t say what happens if there are still proceeds beyond that maximum. Isn’t this capping the upside, which we said in the last section was idiotic?
Well, yes, but… Later on in the Term Sheet, under Optional Conversion, you see that the preferred shareholders can convert to common stock any time they want to. The language is:
The Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described below under “Anti-dilution Provisions.”
You need to take these two quoted sections together. If we are getting our return “capped” under Alternative 3’s terms, we simply convert to common. We then own our share of the common stock and split the proceeds proportionally. Not capped now!
In practice, the Term Sheet translates into the company’s Certificate of Incorporation, which solves this apparent cap by being clearer that the Series A shareholders get the as-converted amount if this is higher than the “capped participating” amount (see page 9, section 2.2, and the extra sentences in footnote 17).
Is this approach unusual? Well, it is option #3 in the term sheet — people generally go with option 1 or 2! — and is slightly more complicated to explain to founders and syndicate partners — hence this article. This extra difficulty makes it less popular than alternatives 1 and 2.
So why use it? Well, it’s a compromise. We will (usually) ask for a 1x participating liquidation preference; sometimes the founders have enough leverage or credibility to convince us to accept a 1x non-participating liquidation preference instead; and sometimes we have to find the middle ground.
(Both parties should also be wary about setting a precedent. Angels might like an unlimited participation now, but a further round (or five) of venture capital money is planned, angels might not like those bigger investors having a participating preference getting paid out first. So we might prefer a capped participation in the angel round. This is partly because a following VC fund should not care so much about it: the capped participation does not impact on the “enormous proceeds” option (#3 above), which is generally the VC investment model, and so might even ignore it.)
What does the capped participation preference mean in practice?
Time for the promised spreadsheet: this sheet lays out the returns for preferred shareholders in (1) a non-participating preference, (2) a (fully) participating preference, and (3) a capped participation preference in various exit outcomes in an example transaction.
The basic investment is:
· VentureSouth angels are leading a $2M preferred equity round to purchase 25% of a company. The preferred has a 1x liquidation preference.
· VentureSouth offered a participating preference (Scenario 2); the company said no, we would like it to be non-participating (Scenario 1); and we compromised at a capped participating preference where the “participating” was capped at 4x (Scenario 3).
· (We’re simplifying a lot here, of course: no fees, no later rounds of equity, no convertible notes messing everything up, no option pools, etc…)
The columns across show different exit valuations and the proceeds for preferred shareholders.
Orange Zone: In the (A) orange zone, we have a fire sale — selling the company for $1M or $2M in columns C and D. VentureSouth has a 1x liquidation preference on our $2M invested; we are therefore entitled to the first $2M of proceeds, so we get 100% of the capital returned here.
(We could consider converting our preferred to common shares, but if we did so we would get 25% of $1M, so less than keeping our preference. Fairly easy decision!)
The liquidation preference is critical here, but the “participation” doesn’t matter — because there are no proceeds above $2M to participate in.
Green Zone: In the (B) green zone, we have an excellent result, selling the company for $33M or more. In this scenario, we have to make different choices:
· (Scenario 1) With no participation, we have to decide whether to take our 1x liquidation preference ($2M) OR convert into common and take our 25% of the $33M+ ($8.25M+). Obviously, we take the higher number ($8.25M+) by converting.
· (Scenario 2) With a (full) participation, there are no choices to make this time: we are entitled to our $2M liquidation preference AND 25% of the remaining $31M+.
· (Scenario 3) With a capped participation, we have to decide whether to take our capped participation (4x * $2M = $8M) OR convert to take 25% of $33M. This is a closer call but still obvious — we take the higher, which is to convert, in cell I26.
Note that most importantly this is not capping our upside: in the $100M exit, we are receiving $25M of proceeds, the same as the non-participating scenario.
It does, though, show the real cost of the compromise in the deal terms. Had we insisted on the fully participating scenario 2, we would have an extra $1.5M of proceeds now.
Lastly, there is a range of fairly attractive outcomes where the capped participation had an impact: let’s review the results from the grey zone.
Grey zone: In the (C) grey zone, we have a moderately good result, but one where the capped participation has a mixed impact. Regardless of the exit amount in this range, our choices are:
· (Scenario 1) With no participation, we make the same decision as the green zone — we have decide whether to take our 1x liquidation preference ($2M) OR convert into common and take our 25% of the $33M or more ($8.25M). Obviously, we take the higher number, so convert.
· (Scenario 2) With full participation, again there no choice to make: we get our $2M liquidation preference AND 25% of the remaining $22M.
· (Scenario 3) With capped participation, we still have to decide whether to take our capped participation (the participating preference up 4x * $2M = $8M) OR convert to take 25% of the exit value. The decision is the same across all this range: we take the capped participation, as that is always higher than converting and taking 25% of the proceeds.
But look what happened there in columns E and H:
· In Column E, our capped participation is juicing our returns nicely, increasing us from $2.5M in the non-participating scenario to $4M in the capped participating. That’s why we included this term, to help improve our outcome in scenarios where the entrepreneur didn’t really deliver on the plan.
· In Column H, though, we are getting maxed out at $8M of proceeds in that “window” of exits between $26M and $32M. In column H, the cap cost us $1.25M compared to the fully participating; but it’s also $0.25M better than had we taken a non-participating liquidation preference. This is giving the entrepreneur some “catch up” for delivering pretty well on the plan.
Make sense? Please make your own copy and play around.
Hopefully between this article and spreadsheet, we have illuminated the cost of the compromise for founders and investors finding this middle ground of a “capping participation.”
If not, at least you hopefully come away knowing that VentureSouth would never willingly cap the total potential upside of our investments — and that if you see a deal with a capped participation you won’t dismiss it.