Preferred Equity Basics Part 2
There Is A Reason Why Preferred Equity is Called Preferred:
Preferred Equity Has a Big Impact on the Value of Common Stock
The terms and conditions on preferred equity frequently issued to venture capitalists may seem arcane, but the impact on the value of common stock (and stock options) is significant! These impacts are important for tax and accounting compliance. But more importantly, they determine the amount of money shareholders will receive when the long hoped-for “exit” is finally realized.
This is the second in a series of posts meant to help explain many of the typical terms for preferred equity we see in our daily valuation work. Hopefully, this analysis will provide some guidance on the impact to the holders of common shares. (There can be legal issues which also come into play, especially in contested matters. However, this blog is not legal advice, and the specific facts and circumstances for any particular case will differ from the examples described herein).
Seniority: Preferred Equity Is In-Between Debt and Common Stock at M&A Exit
The preferred stockholder’s liquidation preference (together with the degree of participation) is a key factor is determining how much, if anything, common stockholders receive in an M&A exit. Participation will be the subject of subsequent blogs.
Most of the companies we see are early stage venture capital backed technology companies. They typically have a capital structure comprised of common stock, preferred stock, and occasionally debt. The exit for an investor is sometimes an IPO, but more frequently, it is a “liquidating event”, which can mean either the company is sold in an M&A exit or the company is shut down. In the case of a liquidating event, the seniority of each component of the capital structure becomes key to whether and how much of the liquidation value is received by each class of shareholder. Take, for example, a company that was funded by $20 million in preferred stock and $5 million in debt. The debt is considered to have first priority on the proceeds available for distribution from the liquidating event, typically the preferred equity has second priority on the proceeds (due to its liquidation preferences), and the common equity has whatever is left over (in this case, it stands third in line). If the company is sold for less than $25 million dollars, the debt holders would get paid off first, the preferred equity holders would get the rest (but not their entire preference amount), and the common stock holders would get nothing. The common stockholders would only receive a distribution if the company is sold for more than $25 million.
Liquidation Preference Multiple (1x vs. 2x) and Similar Provisions
In many cases, the liquidation preference is “1x”, which means the preferred equity gets one times the amount they invested. In the example above, the preferred equity put in $20 million, so the amount of their liquidation preference is $20 million.
However, a liquidation preference can be “2x” (or “3x” or some other multiple), meaning the preferred equity gets back twice the amount invested before any proceeds are distributed to common stockholders. In the example above, the preferred equity would get back $40 million.
In some cases, there may be a mandatory dividend on the preferred, or the liquidation preference is structured so that the amount of the liquidation preference grows at a specified rate (e.g., 8% per year non-compounding) until the exit event. In the above case, assuming a three-year term to exit, the liquidation preference for the preferred equity would be $24.8 million. The key point is that liquidation preferences greater than 1x mean that the common stock holder receives nothing until and unless the preferred equity holder receives a return of capital plus a specified amount of profit.
Liquidation preferences provide preferred shareholders with downside protection on their investment. In some cases, liquidation preferences also provide for a profit. Of course, the assurance is not absolute. At an exit, legally enforceable obligations (such as debts, lease commitments, legal judgments, etc.) must be satisfied first. However, once these first priority claims are satisfied, then the preferred stockholder is second in line and ahead of the common stockholder.
The preferences of preferred stockholders do not end with just the liquidation preference. In the next blog, I will describe what happens after the preferred stockholders receive the liquidation preference in an M&A exit through their participation rights.
Other Posts in this Series
Preferred Equity Basics Pt 1: VC Differences
Preferred Equity Basics Pt 3: Participation Rights
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Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.
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