By Paul A. Jones of Michael Best & Friedrich, LLP
In an earlier blog (Capping Preferred Participation: A Compromised Compromise), I argued that the usual middle ground between entrepreneur-friendly “non-participating” preferred stock and investor-friendly “participating” preferred stock – capping participation at some multiple of an investor’s base preference – is seriously flawed. Herewith an alternative approach.
By way of a quick refresh, we are talking about “participation” in the context of a preferred stock liquidation preference. In an exit transaction, other than an IPO, an investor holding “participating” preferred shares gets two bites at the exit proceeds apple. First, a bite equal to his base preference (typically an amount equal to his investment) and then a second bite equal to his pro-rata share of the remaining exit proceeds.
An example: An investor who put down $1 million for a 40% ownership position in Newco in the form of “participating” preferred shares would, in the event Newco was sold for $3 million, receive $1 million “off the top” and in addition 40% of the remaining $2 million of proceeds for a total of $1.8 million. That means the investor, who owned 40% of Newco when it was sold, would get 60% of the exit proceeds. If instead, the investor held “non-participating” preferred shares he would receive either (i) his $1 million base preference or (ii) his 40% pro-rata share of the $3 million or $1.2 million. Clearly, the investor would take the $1.2 million pro-rata share and leave the entrepreneur with $600,000 more money than he would have had if the investor had held participating preferred.
Looking at the above example, it is not hard to see why entrepreneurs don’t like participation and investors do. While the relative impact of the participation right diminishes as the exit proceeds rise (in the example, the difference is always $600,000), at every exit that leaves anything for the common shares, the investor with participating preferred gets more and the entrepreneur less.
In light of the above, entrepreneurs and investors long ago came up with a compromise on the participating/non-participating issue, the so-called “participation cap.” As with non-participating preferred, “capped” participating preferred gives an investor a choice. When exit proceeds are being distributed, the investor can choose to take either his pro-rata share of the proceeds (his percentage ownership at the exit) or his base preference plus participation in the distribution of the remaining proceeds until he has received in the aggregate an amount up to some multiple – say 2x or 3x etc. – of his base preference.