The Preferred Return
If you are an entrepreneur, you need to understand preferred stock: what it means, what it implies and why investors secure their investments with it.
Preferred stock is a class of stock that provides certain rights, privileges, and preferences to investors. It is senior and superior to common stock, which is what founders usually hold. Most VCs will invest in preferred stock, at least we always do in DILA, and so it is very important for founders to understand the nuts and bolts of these shares and the Preferred Return.
Preferred shares are named “preferred” because they have a preference of collecting money before the common shares. So, basically, they are the first in line to collect cash in case of a liquidity event: this could be the sale of the equity of the company or the sale of assets in case of bankruptcy.
The preference may come in many shapes and forms and it is all up for negotiation. Let’s start by understanding what types of preference may exist:
- Participating preferred — Participating preferred shares receive an amount equal to their initial investment plus accrued and unpaid dividends upon a liquidation event. Then, this stock participates on an “as converted to common stock” basis with the common stock in the distribution of the remaining assets. So, participating stock holders receive their preferred return and then participate in the common stock distribution on their pro-rata basis.
- Non-participating preferred — this is what we always use in DILA, and it is would I would call “standard” in an entrepreneur friendly term sheet. This means the exact opposite of the participating because the holders of non-participating preferred have the option of either only receiving their preferred return or converting their shares into common stock. In a non-participating scenario, holders of common stock receive the remaining assets after the preference is paid. If holders of common stock would receive more per share than holders of preferred stock upon a sale or liquidation, then holders of preferred stock 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. We believe non-participating preferred stock is more entrepreneur friendly because the liquidation preference becomes insignificant after a certain transaction value.
- Multiple of capital invested preference — the threshold return could be presented in a multiple of the capital invested by the preferred shareholders. This can be presented as 1X for example, where the hurdle rate is one times the capital invested or 2X, where the hurdle is two times the money invested, and so on.
- Return preference — the threshold could also be presented with an interest rate. If, for example, the preferred return is set at 8%, then the holders of preferred shares receive their capital invested plus an 8% interest on their capital.
Lets use these in an example: DILA owns 25% of company A, it invested $1M. The company is sold for $4M. If DILA owns non-participating shares with 1X preference, then DILA would be indifferent between converting their shares to common or receiving their preference; in either case they would get back their $1M. If, however, DILA had participating preferred shares, then it would receive $1M and then participate in 25% of the proceeds of the $3M left, so DILA would receive $1.75M in total. If the threshold was set at 2X, then it would receive $2M with non-participating preferred and $2.5M with the participating preferred.
Why we ask for it: it’s a protection. We are investing in highly risky projects and we are normally valuing those projects based on future cash flows. Is the company really worth that much today? No. So, we need to protect our LPs’ capital.
Here is another example: DILA invests $2M in a company you started a few months ago, of which you own 100% of the shares, and values your company at $6M pre money. Now, the company is worth $8M, DILA owns 25% and you have $2M in the bank. If you decided to liquidate the company tomorrow and divide the money equally between shareholders, you would get $1.5M and DILA would get $.5M. What a great deal! You started a company some months back, you raised money, liquidated and obtained $1.5M! DILA, on the other hand, invested $2M and lost $1.5M the next day . . .
This might be a very extreme example, but i believe it illustrates the importance of protection for investors in early stage companies.
Being extremely pragmatic and simplistic, in any startup there are basically three scenarios: the company does extremely well, the company does OK or the company fails. If the company fails, no one (not even the preferred shares) get anything, so let’s leave that aside. If the company does extremely well, then the preferred shares also don’t matter because once you reach a certain valuation the preference is no longer valid. So, the preference is only important and applicable if the company does OK. In that case, investors need to protect the money they invested. In DILA, we are not aggressive with our hurdles, nor do we use participating preferred structures, we simply protect our investment by issuing preferred shares.
There are many other terms and conditions that come along with preferred shares, (such as board seats, information rights, provision rights, among others) but I will leave those for future posts.
Looking forward to hearing your thoughts and comments.