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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Startup Valuation, Preferred Stock and Common Stock Prices

July 17th, 2008

This post may get a bit wonky.  I’ll do my best to keep it straightforward.

I have talked to a lot of people in my career who get confused by the value of shares of stock in a startup company.  A venture-oriented company has two or more different kinds of shares with different values attached.  Here’s how to keep them separate.

Pre-Money, Post-Money and Per-Share Value
When a company does a financing, it sets a value for the entire company- the “pre money” valuation before the new money comes in.  Let’s say the value is $10M.  If the company has 5M shares outstanding, this means that each share is worth $10M/5M = $2.00.  This is the price investors will pay to buy stock in the company.

If the investors are putting in $5M, they are buying $5M/$2 = 2,500,000 shares.  The company now has 7.5M shares outstanding, and the total “post-money” valuation is $15M.  We can see by the numbers that on a per-share basis (2.5M/7.5M) and a dollar-value basis ($5M/$15M) that the investors now own 1/3 of the company.

Common Stock vs. Preferred Stock Pricing
The part that gets tricky is that investors buy preferred stock, but the company also has common stock that it will issue to employees.  Preferred stock has superior rights, especially including a right to get paid first when the company is sold.  By convention and IRS rules, we are allowed to say that the preferred stock is worth more today than the common stock.  Thus, when we sell preferred stock to investors at $2.00/share, we can give options to employees to buy common stock at a much lower price- $0.30 or so.

This works well for the most part.  Investors want certain rights that employees don’t care about and pay extra for them.  Employees would rather get low-priced options than the preferred rights.  Everybody is happy.

But I Thought Each Share Was Worth $2.00?
The place people get tied up is comparing the enterprise valuation with the common/preferred stock differential. We valued the entire company at $10M, which meant that each share was worth $2.  At the same time, we say that common stock is not worth $2 and is only worth $0.30.  Which is true?  Both.  Here is how and when to use each number.

Enterprise Valuation is for the Big Picture and Financings Only
When we value the company for a financing, we put a value on the whole company as though it is about to be sold.  We take into account all of the economic preferences and assume that all stock is converted to common.  Every share is the same at that point.  In other words, if the pre-money valuation is $10M and the company has only common stock outstanding, each share is worth $2.  The valuation is really forward-looking to an eventual exit.

Common Stock Price is For Employees Today
Until that happens, though, we maintain different types of stock with different rights- common and preferred.  The preferred is sold based on the as-converted valuation, but the common has fewer rights and we can issue options at a lower price.  The company’s total valuation continues to be $10M and each share would be worth $2 on a sale of the company, but before that happens each share of common stock is actually worth $0.30.

The Simple Rule
The easiest way to think about this is that preferred stock is for investors and common stock is for employees.  Be aware that pricing is set differently for each.

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