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Understanding Critical Components
By Andres Navia
Our Portfolio Manager Andres Navia is at it again! This time he really digs in on preferred stock term sheets. There are many aspects to these term sheets that are critical for founders and investors to understand in all areas from cap table impacts to corporate governance. Our ideal here is that the negotiation process is made clearer and more productive with this knowledge and that all parties are established for success across various rounds of investing and raising money.
A typical investment process has some variation of the following 6 stages: 1.Sourcing, 2. Screening, 3. Preliminary due diligence, 4. Term sheet, 5. Final due diligence, 6. Closing. One stage leads to the next. Once an investment is screened, it proceeds to the preliminary due diligence stage. A term sheet is typically offered in between the preliminary and final due diligence stages, and that’s when negotiations usually begin. This is intentional because it sets the zone of possible agreement (ZOPA) early and indicates the possibility of reaching an agreement before investing more time and resources into a deal.
A term sheet is an agreement that outlines the basic terms and conditions of an investment. It summarizes the principal terms of the financing and serves as a template and basis for more detailed, legally binding documents. The No Shop/Confidentiality and Counsel and Expenses provisions are typically binding obligations of the company whether or not the financing is consummated. This is in consideration of the time and expense devoted and to be devoted by the investors with respect to the investment. But no other legally binding obligations are created until definitive agreements are executed and delivered by the company and the investors. The term sheet is not a commitment to invest, and it’s conditioned on the completion of due diligence, legal review and documentation that is satisfactory to the investors, but it determines the final deal structure and is a blueprint for the relationship between the company and the investors. Once the company and the investors reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is drawn up.
Note: At Poseidon we believe in dialoguing about the general type of investment (preferred stock, debt, etc.) prior to submitting a term sheet since we want to be sure that all parties are considering early diligence along the same lines. This doesn’t always work, but we try.
Founders receive common stock when companies are created. VCs purchase preferred stock when they invest. Common stock is the basic unit of ownership, it doesn’t carry any special rights outside of those described in the company charter and bylaws. It gives the holder ownership, but that ownership is subordinated to employee claims, liabilities, taxes, and preferred stock. If the company is liquidated, common stock shareholders stand behind all of those other obligations and stakeholders before getting any proceeds.
VCs don’t typically purchase common stock. The main reason is to keep incentives aligned and focus on value creation. Preferred stock eliminates the possibility of misaligned incentives. Common stock financings technically allow founders to sell their company after a financing at a lower valuation. This may be attractive to the founders, but it clearly won’t be beneficial to the investors since the value of their ownership would be less than their original investment. In this scenario, the value of the founders’ ownership would likely incur an unrealized gain at the financing, and then it would incur a realized loss at the sale. But overall, the founder would incur a realized gain. From the founder’s perspective, a bird in the hand is worth two in the bush. The investor, on the other hand, would be powerless throughout the process, and would incur a realized loss on their investment.
This is why VCs purchase preferred stock when they invest. Preferred stock gets its liquidation preference through a redemption of the preferred stock. VCs value a company based on its potential value, not its current tangible value. They can try to meter their investment into a company using staged, milestone-based financings, and this can help to finance the company in proportion to the value that’s being created and to the expenses incurred, but founders usually need to finance their company ahead of their expenses, and value is created in lumps coincident with important events like major successes in the marketplace. So, the founders’ stake should be perfected when they have delivered on the promised value. If the founders sell their company after a financing at a lower valuation, they haven’t earned their equity and are essentially violating the principle of reward for performance.
Note: it’s important to remember that receiving an investment is an acceptance of fiduciary responsibility. Investors are placing their confidence in founders and managing teams, so this alignment is a fair consideration. As fund managers, we also have fiduciary responsibility, which is always at the heart of the investment decisions.
Preferred stock has a liquidation preference over common stock. The liquidation preference is the second most important economic term after price. The liquidation preference impacts how the proceeds are shared in a liquidity event. In a liquidity, the preferred stock gets paid ahead of the common stock. A liquidity event includes mergers, consolidations, acquisitions, sales, leases, transfers, exclusive licensing, change of control, and any other disposition of the company. Investors are also entitled to their liquidation preference even when part of the consideration is subject to escrow.
There are two primary components that make up the liquidation preference: the actual preference and participation. The actual preference states how the proceeds shall be paid in the event of any liquidation, dissolution or winding up of the company. Typically, a certain multiple of the investment or cost basis is paid to the investors before holders of common stock receive any proceeds. That’s the face value of the preferred stock. The participation states how the balance of any proceeds after the payment of the preference will be distributed. Participating preferred stock receives its liquidation preference or face value, and then it participates in the pro rata distribution of the balance with the common stock on an as converted basis. Nonparticipating preferred stock only receives its liquidation preference, it doesn’t participate in the pro rata distribution of the balance with the common stock.
Liquidation preferences across multiple series of financing can vary and become complex. There are two main approaches: stacked and blended (i.e., pari passu). With stacked preferences, follow-on investors stack their preferences on top of each other where the Series B investors get their preference first, and then the Series A, and so on and so forth. With blended preferences, the series of financing are equivalent in status and they share pro rata until the preferences are returned. If you have a stacked Series B, you can expect to have stacked preferences in all subsequent rounds. Similarly, if you have a participating preferred Series A, you can expect to have participating preferred in all subsequent rounds where the preferred stock receives their liquidation preference or face value, and then participates in the pro rata distribution of the balance with the common stock on an as converted basis.
The liquidation preference is an important term that’s part of all institutional preferred stock financings. Nonparticipating preferred has become the standard early-stage security over the years where the preferred shareholders essentially get their outstanding principal back. Since companies now typically raise multiple rounds of financing and later stage investors usually pay higher prices, stacked preferences have also become the standard where later stage investors get their preference first in a LIFO (last in, first out) method. Similar to the earlier scenario, if the founders and the earlier investors decide to sell the company after a later financing at a lower valuation, the later stage investors would lose money if they didn’t have a stacked liquidation preference.
There are different types of preferred stock. Redeemable preferred is preferred stock that has no convertibility into equity. Its intrinsic value is its face value plus any dividend rights that it carries. Public companies issue preferred stock with high dividends that are preferential to common stock dividends to attract certain classes of investors who desire high income streams. VC securities generally carry no dividend rights because VCs are capital gains oriented. Many VC limited partnerships don’t grant a carried interest to the general partners on dividends received. Dividends also limit the ability of a growth company to raise capital since it raises the dilemma of paying shareholders versus investing in growth. Dividends can also create an asymmetry of rewards between the preferred shareholders (i.e., the investors) and the common shareholders (i.e., the founders, management, and key employees, or simply put, the company). The use of preferred stock in VC securities is based on the value of the liquidation preference value and the earnout principle, and it shouldn’t be confused with the use of preferred stock in public companies. I won’t discuss dividends in this post since they typically don’t play a role in VC securities.
Redeemable preferred in a capital structure behaves like subordinated debt. It always carries a negotiated term specifying when it must be redeemed by the firm. It’s used in private equity transactions in combination with common stock or warrants. In the earlier scenario, if the financing is in the form of redeemable preferred stock plus common stock, and the founders decide to sell the company after the financing at a lower valuation, then the transaction redeems the redeemable preferred stock first, and then the residual value is divided pro rata. If the company does a successful initial public offering or is successfully acquired, the redeemable preferred stock is redeemed, and the investor gets to keep her common stock ownership in the company.
Convertible preferred stock is preferred stock that can be converted into common stock at the option of the shareholder. The shareholder chooses whether they will exercise their liquidation preference or convert to common stock. If the value of the shareholder’s ownership at exit exceeds the value of the liquidation preference, the shareholder will convert the preferred stock to common stock. In the earlier scenario, if the financing is in the form of 1x convertible preferred stock (i.e., 1x liquidation preference), and the founders decide to sell the company after the financing at a lower valuation, then the transaction redeems the convertible preferred stock first similar to the redeemable preferred stock, and the founders get the residual value. The investors would request to redeem their convertible preferred stock because the as-converted value of the convertible preferred stock would be less than the value of the liquidation preference. If the founders decide to sell the company at a higher valuation, the investors will request to convert their convertible preferred stock to common stock since the as-converted value of their convertible preferred stock would be greater than the value of the liquidation preference.
Convertible Preferred Stock and Redeemable Preferred Stock plus Common Stock differ at the time of exit as follows:
Proceeds <= Face Value (FV) (i.e., Liquidation Preference): All proceeds to convertible preferred stock
FV < Proceeds <= Post Money Valuation: FV to convertible preferred, balance to common stock
Proceeds > Post Money Valuation: Distributed pro rata on an as-converted basis
Proceeds <= Face Value (FV) (i.e., Liquidation Preference): All proceeds to redeemable preferred stock
FV < Proceeds <= Post Money Valuation: FV to redeemable preferred, balance distributed pro rata to common stock
Proceeds > Post Money Valuation: FV to redeemable preferred, balance distributed pro rata to common stock
Participating convertible preferred has become the standard late-stage security since later stage investors usually pay higher prices. Participating convertible preferred stock receives its liquidation preference or face value, and then it participates in the pro rata distribution of the balance with the common stock on an as converted basis. Participating convertible preferred stock generally has terms that make it act more like redeemable preferred stock while the company is private, convert to common stock if the company goes public, but participate in a liquidation event. For example, in a merger between two private companies, the participation term is triggered when Newco issues new preferred stock in exchange for the existing participating convertible preferred stock. The participating convertible preferred shareholders receive new preferred stock equal in face value to the value of their participating convertible preferred stock’s liquidation preference or face value, plus their pro rata share of common stock. This can be quite dilutive to management and existing shareholders, but it’s become the standard to keep incentives aligned and continue focusing on value creation since the later stage investors usually pay higher prices.
The different preferred structures differ at the time of exit as follows:
Proceeds <= Face Value (FV) (i.e., Liquidation Preference): All proceeds to participating convertible preferred stock
FV < Proceeds <= Post Money Valuation: FV to participating convertible preferred, balance distributed pro rata to common stock
Post Money Valuation < Proceeds <= Implied Equity Value at Initial Public Offering: FV to participating convertible preferred, balance distributed pro rata to common stock
Proceeds > Implied Equity Value at Initial Public Offering: Distributed pro rata on an as-converted basis
Proceeds <= Face Value (FV) (i.e., Liquidation Preference): All proceeds to convertible preferred stock
FV < Proceeds <= Post Money Valuation: FV to convertible preferred, balance to common stock
Post Money Valuation < Proceeds <= Implied Equity Value at Initial Public Offering: Distributed pro rata on an as-converted basis
Proceeds > Implied Equity Value at Initial Public Offering: Distributed pro rata on an as-converted basis
Proceeds <= Face Value (FV) (i.e., Liquidation Preference): All proceeds to redeemable preferred stock
FV < Proceeds <= Post Money Valuation: FV to redeemable preferred, balance distributed pro rata to common stock
Post Money Valuation < Proceeds <= Implied Equity Value at Initial Public Offering: FV to redeemable preferred, balance distributed pro rata to common stock
Proceeds > Implied Equity Value at Initial Public Offering: FV to redeemable preferred, balance distributed pro rata to common stock
Price is the most important economic term. While price per share (PPS) is the ultimate measure of what’s being paid for, price is often referred to as valuation. The valuation is what the investor is valuing the company at today after receiving the investment. This is the post money valuation. The pre money valuation is simply the post money valuation minus the contemplated investment and minus the outstanding principal and unpaid accrued interest on convertible promissory notes. When an investor says that they’ll invest $10m at a valuation of $40m, they usually mean $10m at a $40m post money valuation and a $30m pre money valuation. The PPS is based upon the fully diluted pre-money valuation. The pre money valuation includes the employee stock ownership plan (ESOP). Both the company and the investors want to make sure that the company has sufficient stock reserved to compensate and motivate its employees, so the size of the pool is taken into account in the valuation of the company and is included in the pre money valuation.
Anti-dilution provisions are an important economic term of convertible preferred stock. The anti-dilution provisions automatically adjust the price if the firm sells stock below the price per share of the convertible preferred stock. The rationale is that the firm is raising a down round (i.e., issuing securities at a price less than the convertible preferred stock’s price) because of underperformance. So, having a provision that automatically adjusts the price of the convertible preferred stock makes it less likely that the convertible preferred shareholders will oppose or forestall a financing when the company needs it most or when the private markets are difficult. Investors have applied the concept of anti-dilution provisions to redeemable preferred stock by similarly having the company issue common shares or pay payable-in-kind dividends to the investors in a down round or if the company misses its targets. But redeemable preferred stock used to be popular with private equity deals when private capital was scarce and investors needed to get their principal back as soon as possible to be able to participate in more deals. For VC financings, convertible preferred stock has become the standard security.
Redemption rights are a very important term that states that the face value of the preferred stock shall be redeemable at the option of the shareholders. This is important since investors have a predetermined expected holding period for every investment and VC funds have a limited life and they have to give their limited partners their committed capital plus profits before the fund expires. Usually, the way this works is that the face value of the preferred stock is redeemed immediately upon request. Otherwise, if the company can’t redeem the face value of the preferred stock, the preferred shareholders are entitled to elect a majority of the company’s board of directors, seek a liquidity event, and have consent rights on company cash expenditures until the preferred stock’s face value has been paid in full.
The pay-to-play provision is another important economic term. It states that all preferred shareholders are required to purchase their pro rata share in subsequent rounds or their shares of preferred stock will automatically convert to common stock. In other words, investors have to keep participating pro rata in future financings in order to not have their preferred stock converted to common stock. Pay-to-play provisions are good for the company and the investors. They ensure full future support of the company, and they impact the economics of the deal by reducing the liquidation preferences for the nonparticipating investors that are no longer supporting the company, which is appropriate.
Note: This provision can dissuade certain investors, such as smaller funds and family offices, given the potential size of their future commitments, which are not feasible for them and would cause their shares of preferred stock to automatically convert to common stock.
The co-sale agreement basically states that if a founder sells shares, the investors will have an opportunity to sell a proportional amount of their stock as well. The investors will have an opportunity to participate in such sale on a basis proportionate to the number of securities held by the seller.
The board of directors provision states the number of members and the members of the board. Investors usually control the board of late-stage companies. Non-management board control provides credibility to the firm and keeps a check on management from exploiting minority shareholders.
Note: Board composition is something that should be considered carefully when partnering with investors and understanding the expectations of investors as the company progresses through rounds of financing will set a strong path to success.
Preferred stock has many more terms. These are some of the most important ones that companies and investors will come across. Thanks for taking the time to read this post on preferred stock.
I hope that it’s helpful, and please feel free to send me any feedback at anavia@poseidon.partners.
Thanks to my team at Poseidon, Emily Paxhia, Morgan Paxhia, and Michael Boniello, for reading drafts of this.