Liquidation Preferences and Participating Preferred Stock: How VC Terms Affect Deals
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- čas přidán 22. 07. 2024
- In this tutorial, you’ll learn about common terms in venture capital investments, such as liquidation preferences and participating preferred stock, and you’ll get simple Excel examples that demonstrate how they affect the distribution of proceeds in M&A deals.
Resources:
youtube-breakingintowallstree...
youtube-breakingintowallstree...
Table of Contents:
0:00 Introduction
1:24 The Short Answer
5:25 Part 1: Company Ownership
8:51 Part 2: Liquidation Preferences
15:57 Part 3: Participating Preferred Stock and Participation Caps
28:29 Recap and Summary
When VCs invest in startups, they normally do so by purchasing preferred stock rather than common stock.
If a VC has preferred stock, and a startup sells itself or shuts down, the VC may choose to keep the preferred stock and its special terms or convert to common stock.
All else being equal, the VC will choose the option that results in the highest proceeds.
In M&A deals, these VC deal terms affect the advice you give clients because they change the distribution of proceeds.
For example, maybe VC Firm A and VC Firm B each own 25% of a company on paper, but because of these terms, if the company sells for $100 million, VC Firm A could end up with $25 million, while VC Firm B gets $40 million.
Company Ownership Calculations
You normally start this analysis by plotting out what happens in each outside funding round.
The main point here is that the number of common share equivalents after each funding round equals the number before the round, divided by (1 - the new ownership created or granted).
So, if there are 5 million shares before the funding round takes place, and VC investors buy 1/3 of the company, there will be 5 million / (1 - 1/3) = 7.5 million shares after the round takes place.
You use this principle to calculate the share count after each round and each investor’s ownership as the company raises more funding.
Liquidation Preferences
This term means that if a VC investor keeps its preferred stock when a “liquidation event” occurs, it will receive a fixed dollar amount (up to the amount the exit proceeds can cover).
This fixed amount is almost always a multiple of the initial investment, such as 1x, 2x, 3x, etc.
If the exit proceeds cannot pay for all the liquidation preferences, payments will be made in order of seniority (the most recent investors are usually the most senior).
Liquidation preferences protect later-stage VCs from investing in a company at a $100 million valuation, only for the company to sell itself for $80 million, or some price less than $100 million.
If there are only a few investors with simple liquidation preferences and nothing else, the calculations are simple:
Step 1: Calculate each VC Firm’s exit proceeds if they were to convert into common stock.
Step 2: Pay out the greater of these common stock proceeds or each VC’s liquidation preference, up to the total remaining proceeds available.
Step 3: Everything left after these VC payouts goes to the common shareholders (the Founders, management, employees, etc.).
Participating Preferred Stock and Participation Caps
This term allows the VC to “double dip” by earning its liquidation preference and “participating” by getting a percentage of the common shareholder proceeds (if it keeps its preferred stock).
It heavily skews the exit proceeds in favor of the VCs, so if this term exists, there is usually a participation cap, such as 2x or 3x, that limits the VC’s total proceeds to a multiple of their liquidation preference.
The decision-making process here can be complicated because each investor group’s actions will affect the best decisions for the other groups, so you normally model out all the possibilities to determine the optimal decision set.
Step 1: Calculate each VC Firm’s exit proceeds if they convert to common stock, and fill in the participation cap and other terms.
Step 2: Calculate and deduct all the liquidation preferences from the exit proceeds based on the conversion decisions (e.g., only deduct these if the investor keeps its preferred shares).
Step 3: Calculate and deduct the Participating Preferred Proceeds based on the conversion decisions and participation caps.
Step 4: Recalculate the common shares and ownership after these distributions based on which investors have converted into common shares or kept their preferred shares.
Step 5: Distribute the remaining proceeds to the common equity investors based on their ownership percentages.
If some VCs have converted into common shares, they count as “common equity investors” in this last step.
![Working Capital and the Change in Working Capital in Valuation and Financial Modeling [REVISED]](http://i.ytimg.com/vi/tMgty8jwmHI/mqdefault.jpg)
Files & Resources:
youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com/Startups-VC/Liquidation-Preferences-Participating-Preferred-Slides.pdf
youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com/Startups-VC/Liquidation-Preferences-Participating-Preferred.xlsx
thanks for still being active. love ur vids!
Thanks for watching!
this is really great content!
Thanks for watching!
Thanks man!
Thanks for watching!
Could you do an example with multiple share classes that have Non-participating liquidation preferences and Pari-pasu seniority structure? I'm struggling with the mechanics of each class recieving their preference equally, but at the same time because share classes have different conversion threshold, one might take their preference and the other might not, which changes the ownership for the exit.
We don't have any examples like that currently, but I will see if we can cover it in the future. In general, though, with pari passu seniority, the normal assumption is that all investors either convert or do not convert. It gets very complicated / is arguably an unsolvable equation if you do not make that assumption because you'll get into cases where one conversion decision affects the total amount of proceeds available to everyone else.
Thank you for the video!
Can you explain please at 27:01 mark, why when we have both participating preferred and convert to common options included, investor B only gets 62,5 mln instead of min ((62,5+40;80))?
I thought when we have participating preferred option investor B should get both his liquidation preference proceeds and proceeds from conversion to common with the restraint of participation cap - so in the example above investor B should get 80 mln, and not the 62,5 as in the video
Correct me if I'm wrong please
If you look at the final output here, the Series B Investors still get $80 million at the end. It's just that in this *intermediate step* we're saying that if the Series B investors convert to 100% common shares, giving up their liquidation preference and the participation cap, they'll earn the $62.5 million.
But they will only convert to common if it results in a better outcome. It does not produce a better outcome here, so they stay in preferred, earn the liquidation preference, and then earn a percentage of the common proceeds up to the $80 million cap.
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Thanks, but no real interest. I like setting my own hours and not having to answer to clients 24/7, so IB is not a great fit for me.
Hi Brian, you are a legend. Quick question, if I was to reformat it and add a Series C, when doing the 'Series B Investors post money ownership' and 'Series A Investors post money ownership' can I still use the numbers from the Series B calculations or does this need be recalculated again?
Thanks. I'm not sure why you would need to recalculate anything (??). The Series A and B rounds still took place. It's just that with the new Series C investors in place, the Series A and B investors will now be diluted and own less, unless they decide to invest more to stay at the same percentage ownership.
Just trying to generalize the steps for the waterfall. My takeaway is: If there were multiple rounds of financing all with liquidation preferences with a mix of rounds that were stacked while others were pari passu and within those rounds some investors were stacked and some pari passu. the liquidation preferences of all investors in order of seniority would be distributed first before moving on to the second tranche: the participating preferred distributions. The final tranche just being common equity distributions and those that also converted to common. Is this correct?
Yes.
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Thanks. We don't cover renewable energy currently except for a few examples that are part of longer case studies in our courses.
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how do you calculate conversion threshold for a series B? At the 25:00 mark? Is it the $40M/25% or the cap $80M/25% ?
It's the $40 million / 25% for the conversion threshold. But at 25:00 here, we appear to be doing something else related to the equity proceeds for the Series B investors.
Also wouldn’t it be more efficient to set up the formulas based off the conversion threshold so you don’t have to flip between ones and zeros on the last column. Cause you know right away if it should be 1 or 0.
Yes, but the issue is that sometimes in more complex models, the correct conversion decision is not always clear from the start because each investor group's decision will affect the others (and this came from a more complicated model). But you could simplify this specific version.
Hello, could we by any chance have your excel file ? Thank you for this video with tons of information !
Click "more" and scroll to the bottom.
It seems like, in the Just Liquidation Preferences section, we're modeling the Series A Investors as 25% owners in a pool of $100M of equity value. Wouldn't we instead want to model the Series A Investors as 33.3% owners in a pool of $60M of equity value, given that Series B does not convert to common and Series A does?
You're correct that if the Series B investors take their liquidation preference, as they do here, the Series A ownership should be based on the remaining $60M and the percentage they own of that (~33% since the remaining investors are 25% Series A and 50% common, and 25% / 75% = ~33%). This tutorial was based on an early version of a few VC lessons , and this specific issue was fixed later (you can check for this case by adding another condition in the formula or setting up separate columns for different scenarios). We're going to delete and re-do this video and split it into shorter segments that better illustrate these concepts. As it doesn't reflect our current VC course and coverage from the past year.
How can we get this template?
Click "More" under the description and scroll down and click the links.
Do you have a VC course?
We cover VC-related topics in Module 14 of the Financial Modeling Mastery course. It's not different enough to justify a whole separate course, as you use similar skills when analyzing startups and growth companies.