Hidden In Plain Sight – How Differences in Preferred Equity Rights Impact the Value of a Company and its Common Shares
Part One – The Impact on Amounts Distributed Upon Exit
Many venture-capital backed technology companies raise capital in multiple rounds of preferred equity financings (Series A, Series B, Series C, etc). At each round, the lead investor estimates the value of the company and submits a term sheet that sets forth the proposed size, pricing, and terms of the new series of preferred stock.
Clearly, the company’s board of directors must evaluate whether the proposed transaction provides sufficient capital to fund the company’s business plan. The board will also consider the adequacy of the proposed price and the other terms and conditions.
Typically, the new investor quotes a post-money valuation (or pre-money valuation) which assumes that every share of equity is equal in value to the proposed price of the new preferred shares. However, as I have blogged before, this “VC valuation” may be very different than the “fair market value” estimated for 409A compliance purposes (or “fair value” as that term is used by the accounting profession). In particular, the VC valuation does not reflect the impact of differences in liquidation preferences and participation rights.
As an example, assume a company’s board is evaluating two term sheets. Both term sheets propose to raise $5 million by issuing 5 million Series A preferred shares at a price of $1 per share. Both term sheets propose a total post-money value of $15 million based on 15 million fully diluted shares outstanding. The Series A shares in the first term sheet have a 1x liquidation preference and are non-participating. In contrast, the second term sheet proposes a 2x liquidation preference and full participation.
• First consider the differences in liquidation preference. The liquidation preference refers to the priority of distribution of the proceeds from an acquisition or liquidation of the company. With a 1x liquidation, each Series A share receives $1.00 (their original issue price) when the company is sold. No other class of equity receives any distribution until the Series A liquidation preference is satisfied. With a 2x liquidation, each Series A share receives $2.00 (2 times the original issue price) before any other distributions are made. Is this example, the 2x liquidation means the Series A shareholders receive a 100% return on their investment before any other shareholder receives a penny, while the shareholders with a 1x participation receive no return but their invested capital.
• Second, consider the differences in participation rights. If a preferred share has no participation rights, then the maximum amount of its distribution is its liquidation preference. The only way the preferred shareholder can receive more per share than the liquidation preference is by converting the preferred share into common stock. However, if the preferred equity is participating, then the preferred shareholder is entitled to share in the available distribution once all liquidation preferences have been satisfied.
Let’s suppose our hypothetical company is subsequently sold for $13 million, the amounts distributed to the Series A and common shareholders will be very different depending on whether the first or second terms sheet was accepted.
• Under the first term sheet, with no participation, $5 million of liquidation preference is distributed to the Series A shareholders and the remaining $8 million is distributed to the 10 million common shares.
• Under the second term sheet with full participation, $10 million of liquidation preference is distributed to the Series A shareholders, and the remaining $3 million is distributed 1/3rd to the Series A shareholders and 2/3rds to the common shareholders. The Series A shareholders receive $11 million in total distributions, while the common shareholders receive $2 million.
As you have deduced, the second term sheet is a far better deal for the Series A than the first term sheet. Of course, other factors may be considered by the board in selecting one offer over the other (for instance, the second term sheet may be from a strategic investor which offers other benefits to the company).
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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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