Great, so you’ve received a term sheet from an awesome VC, but it asks for 3x participating preferred equity. 3x participating preferred means that the investors get 3x their money back first, and then split the remaining monies based on their ownership percentage. So, as an example the investors might put in $3M at a $7M pre-m0ney valuation, for a post-money valuation of $10M and a 30% stake in the business. With a 3x participating preferred position, example exit outcomes are as follows:
- Startup sells for $10M, investors get $9.3M (3x their investment (3 times $3M) and then 30% of the remaining value (.3 time $1M)), and other shareholders get $700k
- Startup sells for $20M, investors get $12.3M (3 times $3M plus 30% of $11M), and other shareholders get $7.3M
- Startup sells for $50M, investors get $21.3M (3 times $3M plus 30% of $41M), and other shareholders get $28.7M
How do you factor that type of liquidity preference into the startup’s pre-money valuation? As you can see by the three scenarios participating preferred equity (sometimes called double dipping) makes for dramatically different outcomes. On the surface it appears the investors own 30% of the business and invested at a $7M pre-money valuation but the numbers above show that with an exit at $50M or less, the actually percentage investors get is really in the 40 – 60% range assuming a decent exit.
One extremely simplistic way to think about participating preferred equity is that for outcomes less than 10x the pre-money valuation, every 1x of participating preferred takes the investors ownership position up 10-20% above their current position (e.g. from 30% ownership to 36% ownership for 1x participating preferred).
What else? What are some other ways you factor liquidity preferences in the startup valuation?
David Cummings on Startups 
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