How does participating preferred affect the exit value for founders and employees?

Participating Preferred allows investors to "double-dip" - receiving a preferred return first, then participating in common shareholder returns. Example: 1.25x liquidation preference, 10% dividend. Investors get: 1) 10% dividend before common dividends 2) 1.25x investment back before common proceeds on exit 3) Then convert to common and share remaining proceeds This captures downside protection via preferred payments. But investors also get upside by sharing in equity value if the company performs extremely well. The "double-dip" from preferred payments plus common upside makes it investor-friendly.

It's a type of stock given to investors that guarantees them their initial investment back first in a liquidation event (like a sale or acquisition). Additionally, they participate in any remaining proceeds alongside common shareholders (including founders and employees) based on their ownership percentage. This "double dip" potential can affect how much common shareholders ultimately receive.

Participating preferred allows the investor to “double-dip” when stockholders are being paid out after a liquidation or exit. First, the investor gets paid an amount equal to their investment amount times the liquidation preference multiple — before the common stockholders are paid. So, if the multiple is 1x, the investor gets paid out as much as they invested in the first place. Then, the investor also participates in the distribution of the remaining proceeds in proportion to their ownership percentage — along with the common stockholders. So, if the investor owns 20% of the company, they are paid out 20% of the balance that remains after they got their 1x multiple. As is evident, participating preferred is very investor-friendly.

Participating preferred stock, after receipt of its preferential return, also shares with the common stock (on an as-converted to common stock basis) in any remaining available deal proceeds. Non-participating preferred stock does not. Put another way, participating preferred stock entitles the holder to its investment amount back (plus an accrued dividend, if applicable) first AND its pro rata “common upside” in the company

A participating preferred is also referred to a 'double dip' for investors as they not only receive their invested capital back before everyone else but then take their equity share of the remaining proceeds. This is usually done to protect their downside but also to bridge a valuation gap between their and managements expectations. It will reduce managements and increase investors returns but the level at which is does so depends on the exit valuation achieved. The higher the exit the less of an effect. It's also why the headline valuation that you see a company achieve may not be the whole story!!

Think of it as the investors getting their money "off the top" before the proceeds are distributed (to them too). Terms changes with markets being hot and cold. In the worst of times it wasn't crazy to see 2 - 3x preferred participating. I would say its not crazy to see a 1x these days... it mainly hurts common (Founders/employees/angels) in low exit scenarios.. but this is also where it is most likely to be demanded by investors. In mid to large exit scenarios its less of an issue. Of course this depends on size of funding.. if you're taking on 100million a 1x preferred is going to bite in anything but a gigantic exit.

Participating preferred share structures: 1) protect the VC’s ROI against lower-than-ideal exit values while… 2) levering common stock shareholders like employees and founders toward being rewarded on an outsized exit. Often times, founders will concede to VC’s taking participating preferred shares in order to get the investment across or use as a lever to come to agreement on a higher valuation. In the scenario of a lower-than-ideal exit value on a company, VC’s often still capture a decent return while common shareholders can sometimes take a hit as big as 20% when cashing out the equity.

A 2023 study by PitchBook revealed that startups issuing participating preferred experience slower average exit valuations compared to those with traditional preferred stock. Additionally, research by CB Insights indicates that founders in companies with participating preferred hold only 25% of the ownership on average at exit, compared to 35% in companies with traditional preferred stock. These data points solidify the potential dilutionary effect on founders and employees. Participating preferred emerged in the early 20th century and gained popularity during periods of high market volatility. Today, it plays a key role in venture capital, particularly in risky or early-stage investments

The timing of the exit value can drastically impact founders/employees more v/s VCs invested. From a Founder's perspective: As capital gets raised, with each round, the employees and founders get diluted much faster than the investors. Other rights to liquidation pref, redemption rights, drag along rights can further impact the founders exit value. From VCs perspective The preferred share holders get compensated for taking on higher risks in a startup given their conversion rights to common stock as well as liquidation prefs to safeguard a min return. Keep in mind, that valuation implication of preferences, especially in scenarios of VCs looking for liquidity can even wipe out founders (eg. ComVentures & Filmloop)

Participating preferred can significantly impact exit value by prioritizing investors' returns, particularly in scenarios with lower or moderate exits. This illustrates how participating preferred terms can diminish founders' and employees' shares in exit distributions, especially in scenarios where the exit value is not exceptionally high.

Participating preferred only really over incentivizes the investors and not the founders If the startup is going well it may be wise to have a clause stating early conversions to common stock or a portion of common stock issued off the get go to ensure maximum investor / founder alignment If the startup fails doesn’t really matter what stock you have it won’t be worth anything anyways The little bit of preferred returns from failing startups don’t make or break a VC’s portfolio but conversion to common stock does If you’re that worried about preferred terms then it makes me question if the investment lacks confidence and maybe convertible debt could be a better route for you and founder for max alignment #vc #venturecapital

There are two primary alternatives to participating preferred: non-participating preferred and capped participating preferred. In the case of non-participating preferred, investors receive their initial investment plus interest, then convert to common stock to share the remaining proceeds pro rata with common stockholders. Capped participating preferred allows investors to participate in the remaining proceeds up to a specified multiple of their initial investment, beyond which they convert to common stock and share the remaining proceeds. For instance, a 2x cap means investors can receive up to twice their initial investment before converting to common stock.

A 2023 study by Harvard Business Review revealed that companies issuing non-participating preferred experience faster average exit velocities compared to those with participating preferred. However, research by CB Insights also indicates that investors are increasingly demanding participating features, highlighting the need for balance between company needs and investor preferences. They play a crucial role in venture capital and private equity, where risk profiles and potential returns demand flexible funding options. As companies strive to balance founder interests with investor demands, understanding these alternatives remains vital.

Arabella, our VC shark, was pondering alternatives to participating preferred stock in her oceanic ventures. She came across two: non-participating preferred, akin to a single feast for investors - they take their initial investment with interest, then swim alongside common stockholders sharing the remaining bounty. The second, capped participating preferred, is like setting a limit to how much investors can eat before joining the common fish at the table. For instance, a 2x cap lets investors double their meal before converting. Arabella’s deep dive into these options illuminates a key insight: different stock structures offer varied ways to balance the feast between investors and company crew.

Negotiating participating preferred terms involves understanding the balance between valuation and participation. While these terms are common in venture capital, founders and employees should seek fair compromises. Requesting a cap on participation, negotiating a lower dividend rate, extending the payback period, or adjusting the conversion ratio for preferred stock can balance participation. Additionally, consider negotiating other terms affecting exit value, like liquidation preference, anti-dilution provisions, voting rights, and board seats. Striking a fair deal ensures alignment of incentives and reduces potential dilution of exit value.

In 2022, food delivery startup DoorDash negotiated participating preferred terms with a 2x cap and a 7-year payback period. This allowed them to secure funding while limiting potential dilution for founders and employees. By employing similar strategies, DoorDash crafted a deal that balanced investor needs with their own long-term goals. A 2023 study by PitchBook revealed that startups negotiating a cap on participation in participating preferred terms achieve an average 15% higher valuation compared to those accepting uncapped terms. Additionally, research by CB Insights indicates that founders actively negotiating terms gain an average 3% higher ownership percentage at exit.

Arabella, our savvy VC shark, faced the challenge of negotiating participating preferred terms. She knew it was like a delicate dance in the ocean, balancing the needs of her fellow sharks (investors) and the school of fish (founders and employees). Arabella advocated for a cap on participation to ensure fairness. She also considered alternatives like a lower dividend rate or a longer payback period, ensuring that the investors' feast didn't leave the others with mere crumbs. Her strategy highlighted the importance of understanding and negotiating terms like liquidation preferences and voting rights, crucial for maintaining a balanced ecosystem where all sea creatures, big and small, could thrive.

Participating in preferred stock (PS) terms can impact founders and employees at exit. PS holders get their initial investment back plus a share of the proceeds, often before others. This misaligns incentives and is crucial in modest exits. For effective negotiation think about the following framework: 1) Limit the participation cap on PS. A lower cap benefits common stockholders by ensuring a more equitable distribution. 2) Clarify conversion terms. Allow investors to convert PS to common stock at their discretion, aligning interests with the company's success. 3) Negotiate lower PS dividend rates. This helps balance investor protection with fairness for founders and employees, leading to equitable outcomes in exits.

In 2022, common stockholders of electric scooter company Bird actively pushed for a higher valuation during their merger with competitor Spin. By leveraging protective provisions requiring common stockholder approval for mergers, they successfully negotiated a 20% increase in the final valuation, safeguarding their share of the exit proceeds. A 2023 study by Stanford Law School revealed that startups with strong voting rights for common stockholders achieved an average 10% higher exit valuation compared to those with limited voting rights. Research by the National Venture Capital Association indicates that common stockholders who actively engage with legal counsel experience 30% fewer legal disputes with company management or investors.

As a common stockholder, protecting your interests involves staying informed on your startup's financials, valuation, and cap table. Regular communication with co-founders, investors, and board members is crucial. Actively participating in shareholder meetings and utilizing voting rights when possible can strengthen your position. Negotiate for protective provisions requiring common stockholder approval for significant corporate actions. Seek legal advice to review contracts and documents affecting your rights, and consider legal representation in case of disputes. Staying vigilant and engaging in open communication are key to safeguarding your interests as a common stockholder.

Good morning! Arabella, our shrewd common stockholder shark, swam smartly in the venture sea. She kept a vigilant eye on the startup's financial currents, staying well-informed about performance and valuation. Arabella regularly communicated with fellow sea creatures – co-founders and investors alike – ensuring her voice was heard in the oceanic boardroom. Exercising her voting rights was crucial, like flexing her fins to influence the school's direction. She also sought guidance from a wise octopus lawyer, skilled in venture capital law, to safeguard her interests. Arabella's voyage highlights that for common stockholders, awareness, proactive communication, and legal acumen are essential to navigate the complex waters of startup equity.

1) negotiating liquidation pref multiple (gen 1-2x) 2) Associating drag-along rights with company milestones will result in a postponement of the timeframe during which these rights can be exercised 3) Allocation of board seats is crucial, as it not only influences the daily operations but also plays a significant role in shaping the long-term direction of the company.

Consider both the participating portion of stock AND the preferred portion. There are levels. Common shareholders are obviously the last to get paid but consider only giving preferred as opposed to participating preferred. You don't have to do both. Consult a good securities attorney but just know there are levels before you get to participating preferred and other creative ways to incentive investors that don't involve you as a founder being the very last to get paid.