As discussed elsewhere, investments in high-growth technology companies are almost always done through preferred stock. This is a form of equity, but it shares some of the characteristics of debt and is quite distinct from common stock.
First, let’s talk about why it is called preferred stock. This has to do with its debt like characteristics. When the company is sold or experiences some other type of liquidation event, the preferred stockholders get their money back before the common stockholders do. (Of course, real debt comes before even the preferred stockholders.)
Ditto on dividends. If the company is fortunate enough to be able to pay dividends, the preferred stockholders may well have a preference there as well, i.e. they get paid their dividends before any dividends are issued to the common stockholders.
Let me back up a bit and explain the term liquidation event. This is a very commonly used and important term since venture investing is all about liquidation events. It refers not to a liquidation of a company in bankruptcy (which was my first thought when I was a baby lawyer) but rather to an event in which the investors’ money becomes liquid and no longer tied up in the company. In the best possible scenario, this refers to an initial public offering. The sale of the company can also be profitable to investors, and these days, there may also be a secondary market among accredited investors that can provide liquidity.
The next important term is the preferred stock’s liquidation preference or just “preference” This is the amount of money returned to the investor in the liquidation event. This is normally the price which the investor paid for his or her shares, but it doesn’t have to be the same. It can, and occasionally has been, a multiple of the purchase price, such as 1.25 or maybe 1.5.
In the venture context, preferred stock normally has the right to convert into common stock. (We will see why in a minute.) This right is called the conversion and the ratio at which the preferred stock will convert is called the conversion ratio. The conversion ratio normally starts off at 1 to 1, but various events can cause that ration to be adjusted, almost always in favor of the preferred stockholder.
Thus (unless the preferred stockholders have uncapped participation rights, explained below) the preferred stockholders will convert their preferred shares into common shares (and give up their liquidation preference) once the value of the common stock in a liquidation event is above the preferred stockholders liquidation preference.
Preferred Stock may often have participation rights – which provide an additional return to preferred stock. Participation rights give the ability of the preferred stock (once it has been paid in full) to participate in the return to the common stockholders. Thus, for each dollar that goes to the holder of a share of common stock, the preferred stock also receives a dollar.
Participation rights come in two flavors, capped and uncapped. With capped participation rights, the preferred stockholders participate with the common stockholders up to some financial threshold, almost always set as a multiple of their liquidation preference. Thus, with a 2x liquidation preference, the preferred shareholders will receive twice their liquidation preference. They will not have an incentive to convert to common stock unless the value of the common rises to more than twice their preference.
With uncapped participation, there is never an economic incentive to convert to common since the preferred stockholders will participate in the full return to the common stockholders and receive their preference as well.
Although participation rights appear very attractive to investors, they have fallen somewhat out of favor in the past few years for reasons Herbert Fockler (a partner at Wilson Sonsini Goodrich and Rosati) and I discussed a few years ago here in Price and Preference.
In the post “How to Value Your Start-Up” I explain the impact of anti-dilution rights. These rights adjust the conversion value of the preferred stock in the event that a company issues additional shares under certain circumstances, the most important of which is a down round financing in which the value of the existing preferred drops below its liquidation preference. There are a number of different types of anti-dilution clauses, which vary in the range and severity of the types of additional issuances, which trigger them. They are sufficiently complex that I will have to discuss them at a future date.
A final important characteristic of preferred stock is redemption rights. This is the right of a preferred stockholder to demand repayment of his or her investment after a certain period of time – normally five years or more. To the best of my knowledge these rights are seldom exercised. If the company actually has the cash flow to pay them, it is probably doing well enough that the investors remain committed. However, a redemption right gives an investor important leverage – particularly if the company has not performed well. He or she can threaten to bankrupt a struggling company unless management concedes to his or her viewpoints on decisions facing the Board of Directors.
Often, preferred stock carries other rights – particularly with respect to voting on certain types of corporate events. But the terms discussed above are the ones that most often affect the economic impact of such shares on a company.