Reading: Division of Returns

An alternative way for the VC to participate in the upside of the company is to adjust the terms of the liquidation preference. Instead of capping the liquidation preference at a certain amount, the deal could stipulate that the VC continues to participate on a pro-rata basis after the liquidation preference has been reached. Such a deal structure is called Participating Preferred Stock or Preferred Stock Packed with Common Equity. 

Here is the typical term sheet formulation for such an adjusted liquidation preference (adjusted text in red):

Liquidation Preference: 

In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows:

First pay [X] times the Original Purchase Price plus accrued dividends on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.

With the convertible preferred that we have discussed in the previous section, the VC had the right to choose between preferred stock and common stock. In contrast, with the participating preferred, the VC receives a portfolio that consists of preferred stock and common stock (from the point of view of cash flow rights).

Example

Let us go back to the previous example and modify it as follows:

• To better participate in the upside potential of the firm, the VC asks for 10 million shares of Participating Preferred Stock.
• In exchange for the higher upside potential, he is willing to reduce the liquidation preference (including dividends) to 9.2 million.
• All other terms remain the same.

How does this modified deal structure affect the payoff of the VC?

• With a liquidation preference of 9.2 million, the VC will get the full payoff up to a liquidation value of 9.2 million. 
• Thereafter, he participates in the liquidation proceeds with common stock pro rata on an as-converted basis.
• With 15 million shares of common stock owned by the entrepreneur, the VC will consequently receive 40% of all liquidation proceeds in excess of 9.2 million. 

The following graph shows the resulting payoff at maturity (green line) for the investor (chart to the left) as well as the entrepreneur (chart to the right). For comparison, the charts also include the payoffs of the three previously discussed financing alternatives, namely common stock (red line), straight preferred (blue line), and convertible preferred (black line)).

Let us, again, use some numerical example to see how the Participating Preferred affects the payoffs to the VC and the entrepreneur:

• Scenario 1: Liquidation value of 9 million
  • VC: With a liquidation preference of 9.1 million, the VC receives the full payoff.
  • Entrepreneur: Payoff of zero.
• Scenario 2: Liquidation value of 25 million
  • VC: The VC receives his liquidation preference of 9.1 million. Of the remaining liquidation value of 25 - 9.1 = 15.9, the VC's share is 40% or 6.36 million. Consequently, the VC's total liquidation value is 9.1 + 6.36 = 15.46 million.
  • Entrepreneur: The entrepreneur receives 60% of the liquidation value that exceeds the VC's liquidation preference, i.e., 60% of 15.9 million = 9.54 million.

Discussion

With the participating preferred, the VC's participation in the upside of the company starts right after the liquidation preference. In contrast, because of the better upside participation, the downside protection is less good. This deal structure gives the VC an stronger incentive to bring in his skills and work together with the entrepreneur to maximize the future value of the firm.