What Happens to Preferred Stock When Your Company is Sold

November 11th, 2008

The phrase in the title of this blog showed up recently in my Lijit search results and it is a great question.  The way preferred stock clauses play out is not totally obvious, either, so here is my summary of the basic principles.  For simplicity, let’s assume these basic facts:

*1M shares of common stock have been issued to founders; and
*A $1M investment at $1.00 per share, meaning 1M new shares are sold and investors own 50% of the company.

Liquidation Preference
Preferred stock has rights that stand ahead of common stock.  The most basic of these (and the only one I will focus on) is the liquidation preference, meaning the amount of money each share of preferred stock will receive if a company is sold or liquidated. This amount is paid to the preferred stock holders before the common stock (founders and employees) gets any money.

The amount of the preference can be negotiated.  At a minimum the preference will be the amount paid, $1 in our example, so that investors know they will get their money back before anything goes to holders of common stock.  I.e. if the company is sold for only $1M the investors get their money back (ignoring any debt, attorney fees, etc.) and common stock holders get nothing.

If investors think the deal is risky they may demand more than a 1x preference.  Liquidation multiples of 2x or more are more common when times are tough and money scarce.  With a 2x liquidation preference our investors would get paid $2.00 for every $1.00 they invested before any money goes to the common stock.  This means the company needs to sell for over $2M before the common stock gets anything out of it.

Participating Preferred
The next question is what happens after the preference amount is paid.  In our 1x preference scenario with a $2M sale the preferred stock gets the first $1M.  What happens to the other $1M?

It depends whether the preferred stock is “participating” or “non-participating”.  Participating preferred splits the remaining $1M with the common stock and non-participating lets the common stock take the full amount.  Clearly, common stock holders would rather see the preferred not participate, while participation is a better deal for the investors.

But What Happens if the Company Sells for a Lot of Money?
These scenarios all assume our company is sold for a relatively small amount of money and show how investors would get their money back when the total payout is small.  What happens if a company hits a home run, e.g. if our company sells for $50M?

Following the rules above, here are some possible outcomes:

$1 preference, non-participating:  $1M to investors, $49M to common
$2 preference, non-participating:  $2M to investors, $48M to common
$1 preference, participating:  $1M preference + 1/2 of remainder = $25.5M investors, $24.5M common

The participation right makes a big difference, as we can see. (and note that the amount of participation can be limited as well, e.g. so that preferred stock gets its preference, $10M based on participation, and then the rest goes to common)

Conversion to Common Stock
The last thing to keep in mind is that preferred stock holders can always convert to common.  So for example, in the two non-participating examples just above the preferred stock would lose out if they only got paid their preference amounts.  Instead, they could forgo the preference, convert to common and share in the sale proceeds based on their percentage ownership of the company.  This would net the investors 50% of the sale proceeds in our example.

Which Leads to Percentage Ownership
The last (obvious) point is that percentage ownership matters.  A 10% owner nets a much lower return than a 50% owner.  This basic fact goes a long way toward explaining why valuations plummet in down markets- investors value the company lower so they can get a bigger percentage for the same amount of cash, and this lets them still make a decent return even if the company sells for a low price.

Wrapping Up
The bottom line is that in almost every situation there is a company sale amount below which the investors are better off staying as preferred stock (this is generally downside protection against low-sale price outcomes) and above which the investors are better off converting to common.  The main variables are the total sale price, amount of the preference, participation/non-participation (and any caps on participation) and the percentage of the company investors would own after conversion.  You can be sure your investors will be doing this math, so you should learn how to work through it as well.

And that’s what happens to preferred stock when a company is sold.

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Preferred Stock and Risk Apportionment

May 27th, 2008

I wrote a post on Gigaom over the weekend that covers the basics of a VC investment term sheet. A couple of the comments wondered whether preferred stock screws the founding team by definition. Another comment there answered the direct point pretty well (preferred stock is just part of the process). Fred Wilson’s post from this morning covers the philosophical angle as well and is worth reading as a complement to the mechanics I spelled out.

To paraphrase him- and dig under the surface of his comments a tiny bit- a VC’s job is to take risks, and so is a founder’s. The founder takes a chance with his idea and livelihood. The VCs risk someone else’s money- and in the process her own livelihood as well, because if none of her investments pan out she is going to be looking for a new line of work.

The VC may also be very active in a business, but not on a day-to-day basis. Ultimately, a VC’s job is to give an entrepreneur some tools to build a company, but the VC has only so much control over how (and how well) the tools get used.

Preferred stock helps line up the relative risks given all of these factors. As a friend of mine put it even more simply, preferred stock offers a mechanism to ensure that if things go poorly, morale runs low and everyone starts to wonder when to throw in the towel, the people actually running the company on a day-to-day basis will feel more pain than the investors.

Sometimes this is enough glue to keep the whole thing together and sometimes it isn’t. I have seen cases where a company has failed and investors have given up some of their liquidation preference so that founders can get *some* cash back. I have also seen preferred stock terms used to enrich investors at founders’ expense. There is no magic about any of it. Cheating and fairness are a function of the people involved; preferred stock is merely the framework on which the VC investment process is built.

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