You are probably all familiar with the term “risk/reward.” The greater the risk, the greater the potential reward. In today’s crazy markets, the “risk free” rate on US Treasuries and German Bonds has been zero and even gone negative (that’s right, investors pay the US Treasury for its promise to repay the debt). When looking at the risk profile of different securities on a continuum, one can envision the familiar yield curve.
As applied to startup technology companies, the common stock issued to the founders (and options exercisable for common stock issued to employees) is at the top of the curve. It doesn’t get more risky than founders’ and employee’s common stock, and that is the security that has the unlimited upside, which is the whole reason for founding/joining a startup.
When investors purchase preferred stock, however, as it relates to the founders’ and employees’ common stock, the investors’ preferred stock jumps off the risk/reward curve and becomes a security that has less risk and more return that the common stock. How is that possible? Through the liquidation and dividend preferences of the preferred stock.
The Liquidation Preference. First and foremost, the liquidation preference means that the investors get their money back in a liquidation of the company (which includes a sale of the company) before the common shares get anything. Let’s say that the investors invest $2MM for ½ of your company. The liquidation preference means that the distributions to the stockholders in a sale of the company are not necessarily going to follow the “ownership” percentages. If the company is sold for $2MM or less, the investors will receive 100% of the sale proceeds of the company. If the company is sold at a value between $2MM and $4MM, the investors will receive $2MM, and the common will receive the remainder, so the minimum the investors will receive is 50% of the sale proceeds. Preferred is convertible to common, however, so if the distributable sale proceeds exceed $4MM, the preferred will convert to common and take their pro rata 50% of the distributable sale proceeds because it will exceed their liquidation preference. With the liquidation preference, the investors have, relative to the holders of common shares, de-risked the investment and shifted their position to the left.
Participating Rights. Another feature of the liquidation preference is that the preferred may “participate” with the common on a sale of the company. Participation means, in essence, that after the payment of the liquidation preference (normally the amount invested by the investors), the preferred will share in remaining proceeds on an as-converted to common stock basis. Returning to our example, if your company were sold for $10MM and the preferred was a fully participating security, then the preferred would receive the liquidation preference of their money back ($2MM), and then the preferred would participate 50% on the remaining $8MM of distributable proceeds, and so receive another $4MM. In this case, the preferred have received 60% of the distributable sale proceeds while only “owning” 50% of the company. Here not only have the investors de-risked the investment, they have achieved a greater return than the common while owning the same number of shares.
Cumulative Dividends. Just to add another wrinkle, a “cumulative” dividend preference for the investors will shift the economics even more. Why do dividends matter? A startup tech company is never going to declare or have to pay a dividend. So true, but if the dividend preference is cumulative, if unpaid it is added to the liquidation preference. In our example, if the preferred have a 10% cumulative dividend and the preferred shares are outstanding for 5 years before the company is sold, then $200,000 is added every year to the liquidation preference. Now when you sell the company for $10MM, the investors will receive a liquidation preference of $3MM off the top, and receive 50% of the remaining sale proceeds, and so 65% of the total sale proceeds, making the investment even less risky and the return even higher vis-à-vis the common for the owning the same number of shares.
So, when you get a term sheet for a preferred stock financing, remember that the economics are not just driven by the pre-money valuation. The other terms of the preferred stock (often called the investors “bells and whistles”) make a bottom line difference when you sell your company.