Reading: Division of Returns

A version of the participating preferred that we have just considered stipulates that the upside participation of the VC is limited to a certain amount. This could be the preferred solution, for example, if the entrepreneur is reluctant to have the VC fully participate if things go really well. Alternatively, the VC could ask for such a structure if he prefers a somewhat better downside protection in exchange for a smaller upside participation. The resulting deal structure is called Participating Preferred with a Cap.

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, 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 [Y] times the Original Purchase Price plus accrued dividends (including the amount paid pursuant to the preceding sentence).

Example

Let us again 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.
• The cap of the payoff is set at an aggregate of 3 times the original purchase price of 10 million (i.e., 30 million).
• Because the upside potential is somewhat smaller than in the case of the fully participating preferred, the VC asks for a somewhat higher liquidation preference of 10 million (as opposed to 9.1 million).
• All other terms remain the same.

 What is new in this deal arrangement is that the total payoff to the VC is limited at 30 million. The question is: When will this payoff be reached?

• We know from the previous analysis that everything up to the liquidation preference (10 million in this case) goes to the VC.
• From the liquidation proceeds that exceed 10 million, the VC receives a share of 40%.
• If the cap is set at 30 million, a maximum of 20 million will be paid to the VC on top of the liquidation preference.
• With an ownership stake of 40%, this maximum payoff will be reached when the liquidation value of the firm is 50 million above the liquidation preference [50*0.4 = 20 million]. 
• Consequently, the VC reaches the cap at a liquidation value of 60 million [= 10 + 50].
• Thereafter, the VC no longer participates in the upside and receives his maximum payment of 30 million.

More formally, we can find the firm value at which the cap is reached (Vcap) as:

\( V_{cap} = \frac{C - L \times (1-\delta)}{\delta} = \frac{30-10\times 0.6}{0.4}\) = 60 million.

with: C = maximum payoff to the VC (30 million); L = Liquidation preference (10 million); \(\delta\) ownership stake of the VC on an as-converted basis (40%). 

The following graph shows the resulting payoff at maturity (black line) for the investor (chart to the left) as well as the entrepreneur (chart to the right). To avoid clutter, we do not show the payoff charts of the other four previously discussed alternatives.

Note that the payoff charts ignore any conversion options the investor might have. To incorporate such an option, we could simply follow the procedure from the previous section. The result would be a so-called Convertible Participating Preferred (with Cap). 

In our case, this Convertible Participating Preferred could be structured as follows:

• Liquidation preference: 9.5 million
• Additional participation rights: Pro-rata as converted (40%)
• Cap on participation rights: 3 times original purchase price
• Convertibility: 1:1 (in this case, conversion would make sense at a value of 75 million or higher)

The following graph summarizes the payoffs of such a Convertible Participating Preferred (with Cap):