Jay Parkhill 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.
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.
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.
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.Tags: M&A, preferred stock, valuation