What is Participating Preferred?
One term that gets contemplated in every preferred stock VC fundraising round is the participation preference. And although it sounds fairly straightforward, it can become extremely complex depending the structure of the preferred stock security. If preferred stock is “participating” (Participating Preferred or PP), that means that during a liquidation scenario (IPO, Sale, etc.), the stockholders of that equity receive their pro-rata share of the pay-out amount on-top of their preference. While there can be various multiples of participation, the most common is simply just 1.0x, meaning that a stockholder receives 1.0x of their preference. The preference is usually the amount that the stockholder invests into the company. Common shareholders don’t receive their pro-rata share until after the preferred stock’s participating gets paid out.
So what does non-participating preferred (NPP) mean? That means that a stockholder of preferred equity has a choice: accept their liquidation participation or accept their pro-rata payout. Either they can receive back their investment (plus dividends, if those are included) or they can receive whatever percentage of the company they own.
I know that might not be the easiest explanation to follow along (I got lost on my way writing it), so let’s look at an example. Let’s say there is a startup called Trophee and they are raising a $1 million series seed financing of preferred stock at a $3 million pre-money valuation from XYZ Ventures. So that means the preferred stockholders (XYZ) will own 25% of the company. Over time, they raise some more money via preferred stock and they eventually get purchased by Microsoft for $100 million. At that point, XYZ got diluted down to owning 5% of the company. So when the sale goes through XYZ is entitled to $5 million of proceeds. If this is a Participating Preferred stock that XYZ holds, then they will also receive their 1.0x preference ($1 million). If it is a Non-Participating Preferred stock, XYZ has to choose between their pro rata ($5 million) and 1.0x preference ($1 million). That becomes a pretty obvious choice to make, but that’s only because it is such a straightforward exit.
When things get dicey and cap structures get messed up, the decision gets a lot more complicated. If a company raises $10 million of participating preferred stock and sells for $15 million, the common shareholders only get to receive their pro rata share of $5 million (including the amount that gets paid to preferred shareholders). If this exit scenario occurred with NPP, then an investor has to figure out if they make more money on the percentage of common stock they own or on their investment preference (this simplifies the process a little bit, but captures the main idea).
So now that I have (hopefully) explained PP vs. NPP, what should entrepreneurs and VCs be thinking about when negotiating this topic? While it may seem like something that is a VC-friendly term and not great for the company / founding team, there’s a lot of thought that should be considered.
So when should NPP be used (and when does it get used)? It should be mentioned that when participating preferred stock gets written into a series seed deal, it is customary for it to get written into all other preferred stock deals moving forward. So that means that if a startup raises a ton of capital, participating preferred can be a significant damper on common stock returns at exit because there is so much capital that has to get paid out before the common shareholders see a dime. This should also be contemplated for early investors too: if you are investing in a company that you know is going to need a ton of capital, keep in mind that if you force PP into the term sheet, it can deteriorate your returns in the long run.
NPP should also be contemplated when considering future investments. There are certain regions of the country that do not like to get into deals that have PP because they think they mess up the incentive structure of a company’s management team. So if a company with PP is trying to syndicate their next round of financing, they might run into some trouble if the term sheet is not found to be agreeable by new investors. The same can be said of the flip-side of that coin, however, where investors won't participating in the deal if it has an NPP structure. This just means that VCs and entrepreneurs alike need to stay current with the financing trends in their industry / geography.
So when should PP be utilized? In general, it keeps an entrepreneur honest regarding how much money they actually need. One of the wonderful things about startups is that they (in theory) require a small amount of capital to achieve a tremendous return. There is a general attitude that startup financing is a business built on lean entrepreneurs and lean cash burn rates. PP can help motivate entrepreneurs so that they don’t raise too much capital and focus on building an actual business on a small budget. Large cash burn rates can be detrimental to the health of a company and they don’t guarantee success. Startups need to be focusing more on keeping a low burn rate and less on having a sick office, kombucha on-tap, and 60 ping pong tables for 30 employees. If you have to rely only on perks like that to grow your team, you might not be good at recruitment or retention. And if you aren’t good at that as a founder, you are in big trouble.
PP also motivates entrepreneurs to go for a bigger exit. I personally don’t buy that it deteriorates the way that entrepreneurs think about returns. Almost every entrepreneur that I have met is an unbridled optimist - that sort of positive enthusiasm for life is an occupational hazard in some instances. But I think that PP can help enhance that high flying attitude and help entrepreneurs think bigger and take more daring risks. And at the end of the day, both venture capitalists and entrepreneurs are in the business of taking big risks.