Participating Preferred Stock Can Skew Valuations

Imagine for a second that you make $50,000/year salary as an employee at a startup. Feeling the entrepreneurial itch, you make the plunge and start a company thinking that one of your first financial goals is to grow the company to the point that you can make $50,000/year in profit. Only, once you achieve $50,000/year in profit, you quickly realize that $50,000 in profit doesn’t equal your previous compensation. As a business owner, to pay a $50,000 salary, you also have to pay employer taxes (roughly 10% or $5,000 in the case of this salary) as well as employee benefits (easily $5,000 per year). Thus, to pay yourself the previous $50,000 salary, it’s really closer to $60,000 in expenses. All the taxes and extras are distortionary in that many people don’t think through the costs involved.

Yesterday’s post titled Example Founder Dilution Over Multiple Financing Rounds didn’t touch on an important topic: participating preferred stock. Much like the example above with salaries, taxes, and benefits, where it isn’t what it seems at first glance, participating preferred stock is also distortionary. The idea behind participating preferred stock is that at time of sale the investors get some multiple of their money back first, typically 1-3x, and then also get their percentage ownership as well. Also known as a double dip, investors with participating preferred equity really own more of the economic interests of the business than their ownership percentage reflects.

Here’s a participating preferred stock example:

  • Entrepreneur wants to raise $10 million at a $40 million pre-money valuation
  • Investors think it’s worth $30 million pre-money, but want to do a deal, so they offer $10 million with a $40 million pre-money, and a 1x participating preferred liquidity preference
  • Entrepreneur accepts the deal and is happy for the perceived $40 million pre-money valuation and investors are happy that they now get $10 million plus 20% of the business in the event of a sale
  • If the business ultimately sells for $50 million, investors nearly double their money ($10 million as part of the preference and $8 million as part of the 20% of $40 million after the preference is removed)
  • If the business sells for $10 million, investors get all $10 million as the preference are stacked in front of the other equity holders
  • If the business sells for $510 million, investors get $10 million plus 20% of the remaining $500 million, for a total of $110 million

In the end, it doesn’t matter too much if the business is sold at several times the original valuation, otherwise, participating preferences significantly skew the perceived valuation. When talking valuations, always clarify if there are any participating preferred preferences.

What else? What are some other thoughts on how participating preferred stock can skew valuations?

5 thoughts on “Participating Preferred Stock Can Skew Valuations

  1. A very useful post – thanks.

    Using the example above, though with 3x participating preferred liquidity preference instead of 1x:

    Investors contribute $10 million. If the business ultimately sells for $30 million or less, investors get everything and entrepreneurs get nothing.

    Read that last paragraph again.

    That’s why these tiny clauses are so important and why entrepreneurs must understand and negotiate hard on them, rather than just focusing on valuation.

    If the business ultimately sells for $50 million (the post-money valuation), investors more than triple their money ($34 million total = 68% of the sale price = $30 million as part of the preference and $4 million as part of the 20% of $20 million after the preference is removed), leaving entrepreneur with $16 million (32% of the sale price).

    On the upside, entrepreneurs get 80% of anything above $30 million selling price.

  2. When I did this for a living, I never wanted to let valuation kill a deal. So, as David says, participating preferences are a way to get the valuation to where I thought it should be, while letting the entrepreneur tell himself/herself that it was where they thought it should be.

    But the original concern (valuation) is really only a dominating factor when you sell the company for less than you hope. We want all our Series A investments to return 10x, but the truth is, many return 1.5x, or 1.0x, or 0.8x… THAT’S when the participation makes a big difference (and when founders can feel that they’ve been screwed).

    If the tree grows to the sky and I’m going to make 10x or more, then one extra multiple of my investment is a lot less meaningful. So if you need to accept participating preferred, try negotiating a provision where the participation ramps down and even disappears at certain (high) exit multiples. The investor usually won’t care as strongly, and it’s a way to put more money in your pocket in a successful exit.

    1. @stephenfleming Thanks for your insight.

      Since a tiny minority of exits are of the 10x or greater type, it makes great sense for entrepreneurs to protect in the instance of what’s statistically likely.

      Of course this likely means accepting a lower pre-money valuation, but that’s a fair (and statistically smart) tradeoff.

      To me, it also makes great sense to accept a lower pre-money valuation in exchange for investors who are the perfect fit for your specific business in terms of the value they will in fact deliver (not just promise).

  3. Mark, Stephen, between the two of you I think you have hit the nail squarely on the head.
    In my experience, when I have asked clients about their exit they looked at me like I had two heads.

  4. David,

    Great post – I’m amazed at the volume of thoughtful posts.

    A great follow-up would be to go into the rationale and process in how the participating preferred ratios are negotiated. Why 1x versus 2x versus 3x?

    And, of course, let’s not forget the regular startup employees who are affected as well.

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