Preferred Equity Basics Part Three

March 29, 2010 at 12:01 pm Leave a comment

There Is A Reason Why Preferred Equity Is Called Preferred:
Preferred Equity’s Big Impact on the Value of Common Stock

The terms and conditions of preferred equity issued to venture capitalists may seem arcane, but the impact on the value of common stock (and stock options) is significant!  While these impacts are important for tax and accounting compliance, more significantly, they determine the amount of money stockholders will receive when the long hoped-for “exit” is finally realized.

This is the third in a series of posts meant to help explain many of the typical terms for preferred equity we see in our daily valuation work.   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).

Participation: Preferred Equity’s Share in an M&A Exit

The preferred stockholders’ participation rights (together with liquidation preferences) are key factors that determine how much, if anything, common stockholders receive in an M&A exit.

In an M&A exit, the proceeds from the transaction are generally distributed according to the priority (or seniority) of the claim.  For instance, debt and other legally enforceable obligations are either paid off or assumed by the acquirer first.  Second, liquidation preferences of preferreds stockholders are satisfied.  Finally, the residual amount remaining for distribution is distributed among stockholders (preferred and common) based on their participation rights.  In some instances, preferred stockholders share the residual amounts equally on a per share basis with common.  In other instances, the preferred stockholders do not receive any amount of the residual, or the amount may be limited to a maximum amount (a “cap”).

In general, we classify preferred equity as either: 1) fully participating, 2) non-participating, or 3) capped-participation:

• Full Participation – means the common and preferred stockholders receive the same amount on a per share (“pro-rata”) basis after the preferred stockholders received their preference amount.

• Non-Participating – means that the preferred shares do not receive any further distribution above their liquidation preferences.  In an M&A exit, the preferred stockholders typically have the right to convert their preferred shares into common stock.  However, they would lose their liquidation preference if they were to do so.  This means that the preferred stockholders will evaluate whether they would receive more per share by converting into common; if the per share distribution is greater than the value of their liquidation preference per share.  If it is, then the preferred equity will convert into common.

• Capped Participation – means that the preferred stockholders (after receiving their liquidation preference) have the right to participate on a per share basis with the common stock, however, the amount is limited (or “capped”) to a specified amount.  Typically, the cap is expressed as multiple of the original issue price.  For instance, the limit may be set at 3x the issue price.  Similar to the case with non-participation, the capped preferred stock holders have the right to convert their shares into common stock.  The preferred shares would be converted into common if the stockholder would receive more than the value of the distribution cap.

Examples

The different form of participation rights can result in very different amounts for the common stockholders (see Figure 1 – PDF).  For example, assume a company has been sold in an M&A exit, and the total amount available for distribution to stockholders is $12 million.  Further, assume the company was capitalized with 1 million shares of Series A preferred stock which were issued at an original price of $1.00 per share, with a 2x liquidation preference.  At the time of exit, there are 4 million common shares outstanding.

• Full Participation – If the preferred shares are fully participating, then each preferred share receives 2x its original price as a liquidation preference, and then receives its pro-rata share of the additional amount available for distribution:
o Series A Distribution per Share  = $1.00 x 2 + $2.00 = $4.00
o Common Distribution per Share = $2.00
o The Series A preferred receives $4 million in aggregate and the common stockholders receive $8 million.

• Non-participating – If the preferred shares are non-participating, then each preferred share receives  the greater of 1) its liquidation preference or 2) its pro-rata distribution by converting into common.  In this case, the preferred shares would receive $2.40 each by converting into common:
o Series A Distribution per Share = $2.40
o Common Distribution per Share = $2.00
o The Series A preferred receives $2.4 million in aggregate and the common stockholders receive $9.6 million.

• Capped Participation – Assume the preferred shares are subject to a 3x participation cap (total distribution per share may not exceed 3x the original issue price).  Each preferred share receives the greater of 1) its participation cap, or 2) its pro-rata distribution if it converts to common.  In this case, the preferred shares would receive $2.40 each by converting into common which is less than the amount of the participation cap of $3.00.  The preferred shares would not convert into common, and the resulting distributions are:
o Series A Distribution per Share = $3.00
o Common Distribution per Share = $2.25
o The Series A preferred receives $3 million in aggregate and the common stockholders receive $9 million.

Conclusion

Liquidation preferences together with the participation provisions are key factors in determining the payouts to stockholders in an M&A exit.  In an IPO exit, typically, the preferred stockholders are subject to automatic conversion into common and these provisions are lost.

Preferred Equity Basics Three — Figure 1 (PDF)
Preferred Equity Basics Three — Figure 1 (Word 2007)

Other Posts in this Series
Preferred Equity Basics Pt 1: VC Differences
Preferred Equity Basics Pt 2: Seniority & Liquidation Preferences

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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Entry filed under: Valuations.

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