An Evolved View Of The Participating Preferred

One of the issues with a trail of 5,000 blog posts going back over seven years is that sometimes you change your mind on something you wrote a long time ago but the words are still out there. That's the case with the issue of the participating preferred.

Yesterday, I came upon this tweet by Vijaya Sagar Vinnakota:

Vijaya tweet

So I clicked thru to the first link and found a post I had written about participating preferred in 2004. In that post I stated "I insist on participating preferreds and get them in almost all of my deals."

Now some of you are wondering what a participating preferred is. I'll give you a brief explanation and then send you off to Brad Feld's blog for a complete description.

In a preferred stock, the investor gets the option of taking their money back in a sale or taking the share of the company they bought. I believe a preferred stock is critical in venture investing. However a participating preferred goes one step further. In a participating preferred, the investor gets their money back and then gets their ownership share of what is left.

Let's do a simple example. Let's say you invest $1mm for 10% of the business. And let's say the business is sold for $25mm. In a preferred (sometimes called a "straight preferred") you get the choice of getting your $1mm back or 10% of $25mm. You'll take the $2.5mm. 

But if you own a participating preferred, you get your $1mm back and then you split the $24mm that is left with the founder. So you get $2.4mm of what is left and the founder gets $21.6mm. You end up getting $3.4mm with the participating preferred vs $2.5mm in the straight preferred.

I grew up in the venture capital business in a firm that had the participating feature in its standard term sheet. I believed it was fair, particularly when there was a cap on "double dip" and that is what I believed in 2004 and wrote in the post I linked to above.

My views on this issue have evolved since then. The participating preferred is not in our standard early stage term sheet. It is not in any of our seed investments. We don't have it in "all of our deals." 

However, we do still use the participating preferred in two circumstances. First, it is a great way to bridge a valuation gap with an entrepreneur. Let's say we feel the business is worth $10mm but the entrepreneur feels it is worth $20mm. We could bridge that valuation gap by agreeing to pay $20mm with a participating preferred. If the Company is a big winner, then it won't matter if we paid $10mm or $20mm. But if the Company is sold for a smaller number, say $50mm, then having the participating feature gives us a return that is closer to what it would have been at our target valuation of $10mm.

The other place a participating feature is useful is when the entrepreneur might want to sell the company relatively soon after your investment. In that case, there is a risk that not much value will be created between your investment and an exit. A participating preferred works well in that situation as well.

In both cases where we still use the participating preferred, we cap it at a multiple of our investment, usually 3x. I mentioned that in my post back in 2004 and I have always believed that a participating preferred needs to come with a cap.

So that's my evolved view of this provision. I believe the venture business has changed as the capital required to create significant value in web services companies has fallen dramatically. That capital efficiency brings new economics to venture investing and terms need to evolve to reflect that. 

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Comments (Archived):

  1. Julien

    I love the fact that all these “tools” and “clause” are eventually just negotiation leverages. The valuation is too high? Ok, then, you ask for participating preferred. I think it would be useful for a site to list all the clause and list their “value” for you as VC. Maybe this involves posting your standard TermSheet and add the clause that you’re likely to ask? this would probably allow the entrepreneurs to understand a bit more of what the VCs expect out of a deal.

    1. fredwilson

      check out brad feld’s term sheet series if you haven’t read it. it is not exactly what you are looking for but it is fantastic…

      1. Julien

        Indeed. Good post(s) by Brad! Saved to Delicious for the next TS we receive :DBy the way, what about a few posts on “negoatiation” (in general, I’m thinking VC deal, but also exit or even customer/provider…) for the monday’s series?

        1. Pascal-Emmanuel Gobry

          Love this idea.

        2. RichardF

          yes it’d be excellent if Fred would give away a few of his inside tips for getting a great deal from a VC 😉

        3. Tereza

          Venture Hacks has written about a relatively new seed Fundraising technique — Mass Syndication — which seems to be what they’re coaching the Y-Combinator co’s to do.It includes writing your own term sheet, using one of the standard ones and based on a very reasonable valuation, and circulating it quickly to a large number of Angels. You’d just ask each one, In or Out?Really interested in what Fred and others think about this approach.The transparency, speed and pragmatism are very appealing to me.

          1. JLM

            What you are describing is the application of simple competitive bidding principles to a marketplace in which the energy is usually exerted from the VC to the entrepreneur.You are reversing the energy field and taking control of your own destiny while sweeping the market in real time. And why the hell not?The Internet, modern communication, standardization of terms and cutting out the middleman (investment banker in bigger deals) makes the application of such fundamental purchasing techniques not just possible but advisable.I would suggest that most deals are typical “7 touch” cold calling exercises, so I might soften the edge just a bit by offering them additional info (PPT, face to face meeting) as the next step rather than just asking them “In or Out”?I raised a bunch of money for syndications by making a group pitch to high net worth individuals at a country club to which I belonged. There was something useful about already being a member of “their” club but it’s a small distinction.The secret is that money WANTS to go to work and you are just helping it get a job. Some folks just inventory money and you are helping them churn the inventory. Do it!

          2. Mark Essel

            Whoa. News to me.It’s like mass mailing but better.First bleeding edge alpha of and this is happening.Included the link to a VentureHacks mass syndication post

        4. Lee Weinberg

          I agree on negotiation ideas in general, not just for VC term sheets — and I am just starting out on my blog that will have some of my favorite “negotiation nuggets” — for example, see this first one, which contains a great negotiation rule to live by:

    2. Kevin Vogelsang

      You can do this fairly quantitatively (well…sort of… at least get a better picture of the “value”) with participating preferred.In the case of participating preferred, what it really does is create what I’d call “effective ownership.” The investor may have %30 ownership (“actual ownership”) according to what the share numbers say, but with participating preferred they’d actually get a higher percent, as Fred has already explained. They get their investment plus their percent. (“Effective ownership” = [Investment$ + % of (Total Return – Investment)] / Total Return)Effective Ownership decreases as the Total Return increases. In the case of a cap (such as what USV uses), the “Effective Return” will be equivalent to the “Actual Ownership” if the overall return is high enough.If you were to graph this out, and I wish I had the time do so, you could see the value this creates. It lowers the investor’s risk by upping the return if the outcome is unfavorable. Fred has explained this process, but if you were to graph “effective ownership”, it would give you a better feel of what participating preferred does when it comes to a liquidity event and how it causes “ownership” to shift depending upon the outcome.Personally, if you think you’re about to hit a home run, and I hope you do, I wouldn’t worry too much about participating preferred with a cap.I wrote this rather quickly, so I hope it’s coherent enough, but I think the idea of “effective ownership” is a good way to map out the effects of this clause.

  2. Pascal-Emmanuel Gobry

    Good points. I would say though that the main reason participating preferred is going away isn’t so much the lower capital requirements of early stage startups (though that’s certainly a big part of it) but also the fact that entrepreneurs today are much more savvy and that there is much more competition for a lot of deals.

    1. fredwilson

      that’s not true because we still get them and get them from very savvy entrepreneurs who know exactly what they are doing

      1. Pascal-Emmanuel Gobry

        Didn’t mean to imply if you accept participating preferred you’re not savvy. My point was more that more first-time entrepreneurs know what participating preferred means and use competition in a deal to get it taken out, at least that’s my experience, but obviously you have more data/experience on this than I do.

        1. Dan Ramsden

          Do you find that we are in a venture environment in which competition happens in this fashion? You’re talking about startups, right? And “first-time entrepreneurs”… Not Foursquare.

          1. Pascal-Emmanuel Gobry

            Every deal is different but my impression from anecdotal evidence is that there is more money chasing early stage deals and that this has an impact on funding terms.PEG

          2. Dan Ramsden

            Yes, there is more money chasing early stage deals, agreed.

          3. George A.

            Pascal, you are probably talking about multiple liquidation preference. In such a case, 1x is the standard multiple. back in the day when vc money was very tight, vc’s would command a 2-3x multiple preference. in this scenario, they ask for 3x return on their investment before common receives ANY portion of the proceeds. This is pretty hardline and is really only reserved for complicated transactions where there is an ugly cap structure prior to the new investment.Multiple LP is very different than what FW is talking about, he is talking about the threshold where the participation right goes away entirely. In his scenario, he takes his preference out first, then participates pro rata on the basis of common ownership, so after 1x, all underlying common is participating. But, when the sum total of his proceeds equals 3x, his double dip goes away.I dislike PP, it sets up a precedent for future rounds and can bury common after you get thru a c round and all investors have pp. Additionally, it creates a dead space in valuation, where VC’s are indifferent within a band as to how much they receive. This goes against the notion of aligned interests. While most of the time this doesn’t happen, it can and that always felt bothersome to me.

          4. Pascal-Emmanuel Gobry

            Right. Thanks for clarifying.

        2. Kevin Vogelsang

          Of course, in any deal, the more leverage you have, the more favorable terms you can get…..

  3. shafqat

    Fred – very helpful stuff. Is a ‘straight preferred’ the same thing as a (single) liquidation preference? How common are liquidation preferences generally and also specifically for USV? If common, are we talking about single or multiple liquidation preferences.

    1. Pascal-Emmanuel Gobry

      As far as I understand, 1X liquidation preference is pretty much the standard for early stage web deals, although 2X and 3X are not uncommon.

      1. fredwilson

        i’ve never seen a 2x or 3x in an early stage deal

        1. Pascal-Emmanuel Gobry

          I’ve seen it asked by business angels who don’t have a lot of web investing experience and get their advice from their lawyers. 🙂 Usually it’s worked out by the savvier investors in the syndicate but it’s not unheard of.

        2. Gabriel Weinberg

          I just did one :). As I was the lead angel, and I seem to be at odds with way more experienced people like yourself, I decided to lay out my thinking:

    2. fredwilson

      yes, a straight preferred is a single liquidation preferencemultiple liquidation preferences are rare in venture stage deals, they happen mostly at really huge valuations where the investor doesn’t think the underlying ownership will generate much of a return

      1. Kevin Vogelsang

        phrases like “multiple liquidation preferences” and “full-ratchet anti-dilution” make me shiver a bit when I read them. Especially “full-ratchet”…sounds nasty as it is….

        1. Tereza

          I’m with you Kevin, sounds rather like there’s a big screw involved.

      2. Tereza

        My feeble marketing mind is having trouble coming up w a scenario where an investor would want to invest in something with a really high valuation if they didn’t expect much of a return from the underlying ownership? Could you give an example? Or is the motivation and value driven by leverage?

        1. ShanaC

          Probably a PE thing, where it is very common to do a shuffle of companies- the leverage is the drive.

  4. Vijaya Sagar V

    Fred,Firstly, thanks for such a detailed reply.I should’ve noticed that I was quoting you from a 2004 post and should’ve asked you where you stand today (just as I asked Chris [@cdixon] for advice in another context).Someone was using your post as a justification in an argument against me on this subject. Given my high regard for you, I was a bit taken aback that you had said something like that. So, I gave up and lost that round of the argument :)As an entrepreneur, since my idea/team/execution meets a VC’s capital/support/advice on equal terms, I always found double-dip tough to digest. But, in the two specific cases you mention, I would grudgingly agree with you about the provision :)My tweet remains for ever on the twittersphere portraying you as some kind of evil VC in comparison. Apologies. I’ll make amends via my blog soon (– vsagarv [ Co-founder – Shufflr: & Althea Systems: ]

    1. fredwilson

      don’t worry about the tweet. i’ve had much worse said about me :)you can’t erase on the web, but you can overwhelm.that’s my strategy

      1. LIAD

        i want to buy stock in the phrase – “you can’t erase on the web, but you can overwhelm”Will become a defining principle of the internet.”Welcome to the web. You can’t erase it but you can overwhelm it.

        1. fredwilson

          david karp, founder of tumblr, got that idea in my mind a few months ago

        2. Vijaya Sagar V

          Hey LIAD, I’d like to take credit for triggering that phrase from Fred. So I hold the first right of refusal for buying it :-)It also sounds like one of those unforgettable Schwarzenegger lines.

        3. paramendra

          I was thinking the same thing. Overwhelm. 🙂

        4. JLM

          Apparently you should ask for participating preferred. LOL

        5. ShanaC

          How much can I overwhelm it- can I remain young forever?

      2. Vijaya Sagar V

        > you can’t erase on the web, but you can overwhelm.Just back from a drive with the family and find this one-liner 🙂 David Karp & you will be quoted repeatedly on this gem.

      3. Vijaya Sagar V

        Fred, I said I’ll make amends, even as you go on your routine of overwhelming the web.I’ve posted about this episode on a slightly tangential note at my blog (… ), calling for RFC-status like features to blogs (/platforms).If some smart chap from college / a drop-out comes along and implements it, I’ll fund the devlopment cost from my bootstrapped entrepreneurial earnings 🙂

    2. Mark Essel

      That’s cool Vijaya just tweet a few dozen pro Fred messages and hope that web searches hit those first 😉

      1. Vijaya Sagar V

        Yes, that’d be a good way to overwhelm the web 🙂

        1. Mark Essel

          If you /cc me I’ll even retweet the positive PR.

      2. Tereza

        Maybe there’s a Twitter add-on app for that. The Oops App.Tweet a retraction and another one that is wildly complementary. Then app guns them out in alternative fashion — say, hourly — for the next 48 hours.The Automated Overwhelm.I’m sure it already exists technically, but someone could package and sell it.:-)

  5. Dan Ramsden

    Fred, do you find that the inclusion of a cap can confuse matters and be a mixed signal for issuer as well as investor? If the opportunity is solid, a cap limits the upside. If the opportunity is murky, a cap is like a meaningless giveaway. If the opportunity is weak, you wouldn’t do the deal. Come to think of it, may not want to do the deal if the opportunity is murky in any case. So as I think through, I can’t imagine a scenario in which a cap is a positive element… Even for the issuer it sends out a bad vibe about investor sentiment. Am I over-thinking? Or missing something?

    1. fredwilson

      the cap is a cap on the participating preferred, not the return. you still get a return on the underlying ownership

      1. Dan Ramsden

        I see, thanks. Misunderstood comment.

  6. terrycojones

    Hey FredAnother way to take the sting out of participating preferred is to create a class of stock for earlier seed investors who also put in cash, and give them a liquidation preference (but no other rights) too. That at least removes the “my new cash is more important than all that earlier cash” feel that irks me about participating preferred: all the stock issued for cash gets to participate (preferably pari passu). The participation still distorts the actual valuation, as you describe, but at least does so more uniformly across all the folks who contributed cash.

    1. fredwilson

      i think everyone who has cash at risk in a deal should have preferred stock. i have no idea why angels do these investments in common

      1. JLM

        I don’t agree with this but —The angels are using their own money and therefore bond with the entrepreneur personally and desire to be on the same footing. It is a personal bonding theme. Much emotion involved. They are “joining” the family.VCs are using OPM and are professional investors dependent solely upon the outcome of the investment. They are making a professional investment decision. They are funding a business. No emotion involved here.Folks investing with personal emotion involved want to be “just like Mike” while professional investors don’t really care about Mike and just want Mike to ship their agreed upon profits.Both are right given their personal views and from whence their money comes.Proof of concept — when successful VCs invest their own money, they are just like the angels. They fund good ideas, in smaller amounts mind you, and don’t calculate the returns to a 4th decimal. They invest in Mike.

        1. Aviah Laor

          Really great comment JLM, and it goes even beyond the angels. The grassroots of the whole industry is Mike’s family and friends that are willing to “raise” money for him.Today this small pre-funding support is enough to launch the first version of the product (or at least the prototype), and therefore significantly reduce the risk for the following investors.However, despite their important role, and relatively bigger risks, it’s very hard to explain and protect their assets down the road.I would argue that for “small” exits, the best and most transparent way would be to provide a simple table that tells everybody how much $ he gets in each scenario (5M, 10M etc).The complex hoola-hoops should be kept for the bigger exists.

      2. Saul_Lieberman

        In addition to the subjective aspects raised by JLM and Aviah… angels traditionally invested smaller sums (per angel and per round) and at lower valuations than VCs. (The gap between angels and VCs on these aspects narrowing.)

  7. Keenan

    There are two themes/stories here.1) Participating Prefered clauses in investment dealsAnd2) The willingness of a blogger/vc to openly admit to a change of stance.Number one is interesting, and informative. Number two is encouraging.In a time when people are far more apt to defend an original idea it is refreshing to see humility and introspection.There is a great book called Mistakes Were Made; but Not by Me which talks about peoples in ability to move off a previous position.Kudos Fred!Young entrepreneurs paying close attention to this post should get more out of #2 than #1.

    1. Tereza

      Agree. It’s the good ole’ pivot. And it’s critical. If something’s not working, ditch it.Although I’m not sure it’s groundbreaking. Don’t people do it all the time?Or is it a male/female thing? Most gals I know are relatively comfortable saying that something evolved so we changed. I mean, if only as a parent I must tweak or otherwise evolve my tact on things almost daily. And these are things that carry equal import to me as my business.

      1. Keenan

        I’m sure many people do it, but few publicly.Sent from my iPad

  8. Fernando Gutierrez

    Don’t you think that if entrepreneur’s valuation and yours are so far away there can be something wrong somewhere? maybe your ideas for the future path of the company are not aligned and that will bring problems… I understand that getting to a value in an early stage company is almost like trying to know the future with a crystal ball, but if any of you is capable of convincing the other part of the rationale behind his valuation maybe someone should think twice.

  9. William Pietri

    Thanks, Fred. This is very helpful.Could you say more about why the double-dip is important in something that exits soon? The way you phrase it it sounds like you’re more concerned with the absolute return on a deal than the return in APR terms. Is that because the time costs of doing a deal weigh more heavily than the money costs?I really appreciate you and other VCs who are pushing for deals that are as simple as possible. Given that entrepreneurs do a lot fewer deals than VCs, complicated terms can provide an opportunity for VCs with a zero-sum orientation to take advantage of the naive. Simple deals are a sign to me that the professional investors are focused on winning together, not separately.

  10. Mark Essel

    I know stuff like preferred and participating preferred stock is important when you invest in many startups. But from a founder view, I just want to ensure that all parties are motivated to generate maximum business value by providing the best damn tools and services to customers.The nuances of general, preferred, or participating stock feels like a distraction. Just agree on how much general stock you’re willing to invest at and move it along. Otherwise it becomes a game for businesses to play in followon rounds to increase perceived value before liquidation.Why conceal or obfuscate the estimated cap of a business, if it’s all common stock comparisons are much easier, exchanges for purchases are also simpler.This is all based on the outsider looking in theory. As always I enjoy understanding the finer points of deals, and valuations.

    1. RichardF

      From a founders perspective I know where you are coming from Mark, however I don’t think 1x straight preferred is unfair from a VC perspective.If at the end of the day all you have managed to achieve is an exit/disposal at the same value or less than an investor (VC/angel) has put in then you haven’t really done your job in my opinion but you’ve probably been paid a reasonable salary along the way and most importantly learned a ton about start up.I’ll caveat the above by saying that I’m sure there are examples out there where a founder feels they may have been forced to sell when they didn’t want to and they lost their initial own investment (life savings) but that unfortunately can be the nature of the game.I always thought multiples were evil until Fred explained it in terms of huge valuations.Doing your utmost to maintain as much control as possible is the issue that most founders should really be concerned about in my opinion.

      1. Mark Essel

        Oh yeah a zero interest loan return is terrible for VCs. A $10 million dollar valuation with $1 million invested that sells for $10 million might be great for a founder but is a bad deal for an investor. The participatory preferred makes perfect sense in this case. But this is the same as valuating the business at $5 million in the first place. The introduction of preferred stock appears to inflate valuations.I’ve read the return stats, investors swing for the fences with and accept a high percentage of failed ventures.

  11. Roman Schwartz

    Fred,I’m an undergraduate student turning in my senior thesis on Monday. I’ve been studying the different provisions that make up the term sheet. One of my findings is a positive relationship between the percentage equity stake investors acquire and the use of participating preferred as opposed to conventional convertible pref. stock. I argue this provides an incentive effect for entrepreneurs to seek that high upside rather than a more modest valuation (your second point). In other words, VCs agree to acquire a larger equity stake (allowing founders to sell more of their company) only by *challenging* the entrepreneur to earn that upside, using participating preferred stock (your first point). As the exit figure gets larger and larger, the liquidation preference becomes less and less material.Now let me ask you this: In your experience, how much of an impact do you think negotiating this and similar contract provisions (e.g., liquidation multiple, anti-dilution provisions) have on the investment amount and post-money valuation? That is, do you find these values to be fixed before the term sheet is negotiated or have you seen different provisions sway the investment amount and valuation significantly?Best,Roman

    1. ShanaC

      I’d like to see that thesis- for there is always a middle ground- too high a number and you are going to blow the poker hand you got.

  12. PhilipSugar

    Very logical discussion.I agree anybody that put in cash should have a preferred position to recover that money first. You can’t argue your cash was worth less than the cash.I also agree that huge valuations where people take money off the table all bets are off.Now to be illogical. Participating Preferred has always just “felt” wrong to me. Just always struck me as greedy. I am saying upfront you can punch holes in this argument all day long, what if you cap, etc, etc. The cap is an interesting point, but I really hate deals where when people are selling everybody is scanning the docs.

  13. goldwerger

    In my opinion participating preferred is one of the bigger ailments of the venture business. I agree with this part of the post. However, I differ on the issue of good places to use them. Generally, I take the view these are simply best avoided as they create structural misalignment between management and investors. It can come sharply into play when selling a company and other situations, where investors and management will win and lose to different degrees, and that is risky. If there is a valuation gap, the value should be negotiated. If there is a risk of someone leaving, vesting should be negotiated. And where it’s not possible to negotiate the core values of the deal, then values do not have a meeting point and better to seek alternate deals…

    1. Kevin Vogelsang

      Smart comment. Specifically, the concept of negotiating the issue, as opposed to negotiating around it. I think we fool ourselves into thinking we’ve dealt with the issue, when we’ve actually just hidden it.In the case of participating preferred, I think it can be useful. As I said in my previous comment, it actually makes “ownership” a variable.And personally, if Fred will give me a better valuation if I agree to participating preferred, I’d gladly take it.

      1. goldwerger

        I’d avoid a participating preferred and take a lower valuation with a better structure (within reason, and of course assuming I am in a position to make this choice).Of course, if Fred gives you a deal then you should take it since he brings so much more than equity to the table, and most of the value in a partnership has got little to do with the original deal terms…;)

        1. Kevin Vogelsang

          This is true. I don’t claim to be an expert, since I haven’t been in on many deals. Simplicity in term sheets is valuable. And an inflated valuation can be detrimental. But personally, call it whatever you want to call it, and just hit hard.

          1. JLM

            Financing is a contact sport but it can still be done in a gentlemanly manner. Remember everybody is going to have to work together when this is all done.

          2. Kevin Vogelsang

            Yep. And relationships are everything.

    2. ShanaC

      The fastest way of changing the structure would be to include the Entrepreneur in the preferred stock so that alignment is equal. (At least give him/her/them a small amount- this would automatically mean cash out at a preferential rate) Preferences would then mean at least aligning valuation, milestones, and investors. The downside is that you’ve created with common a class of Peon shares for your workforce. (I’m being slightly sarcastic/funny with that last line).However, it seems to be something within the structure of the stack of preferred versus common and how this relates to liquidity events when it comes to participating.Even this public shift shows a growing change about bubbliness. I’m not sure I like it- some hesitancy is good.

  14. paramendra

    Yet another reason why you will not write a book. 🙂

  15. rudy3451

    In the example scenario, (4th para. from bottom of post), I believe there’s a typo…? The company would have been sold for $5mm, not the $50mm stated, correct?

  16. David Semeria

    <broken record=””> Preferences (whether straight or participating) fly in the face of investment theory. Their mere existence hints at an inefficient market for venture capital. You either pays your money and you takes your chance, or you don’t. But you can’t have it both ways.</broken>.

    1. ShanaC

      Agreed- it also explains why if you have preferences in multiple rounds they can get very screwy based on the stack of preferred shares. Not all exits are the same to all investors, and it can cause screwy misalignments.

  17. JLM

    At the end of the day, “preferred” just means you are in front of the common or junior preferred in a liquidation scenario or a profits distribution scenario. It determines your place in line.Whether you are convertible, participating, coupon preferred just determines how much you get paid when the money gets to your place in line.There is no line unless there is some money to distribute. The best scenario is distributing profits rather than liquidation proceeds.”In life, you don’t get what you deserve, you get what you negotiate.””Everything in life is negotiable.”The valuation determines everybody’s initial negotiating position. When there is disagreement on the valuation, then the negotiations begin. The magnitude of the valuation disagreement determines the virulence of the negotiations. The negotiations end when the valuation disagreement is bridged. Negotiations are all about building bridges across the valuation gap.Entrepreneurs should use the power of competition to tighten up the gap, if they can. Competition is a powerful ally. VCs should use creativity (e.g. participating preferred) to bridge the gap, if they can.Negotiate a deal everybody can live with — no scars in the process — and go make some money.Learn something you can use next time but go make money.

    1. David Semeria

      The best scenario is distributing profits rather than liquidation proceeds.The term ‘liquidation preference’ is misleading. Although they can also be used in a liquidation scenario, the main scenario is a the sale of a going concern.Liquidation preferences are a bit like convertible debt. They have a guaranteed* yield (and a prior claim on assets) and can be converted into straight common. Participating preferred are particularly odd because they simultaneously exhibit the characteristics of a bond and an equity – and in doing so disprove the Heisenberg Uncertainty Principle ;-)*In so far as anything in life is guaranteed.

      1. JLM

        Agree completely however with one third of all VC investments ultimately being flop sweat failures, it is not an insignificant consideration.

        1. David Semeria

          Up to a point. I would love to be able to buy into the stock market (at the going price of common) but with a guaranteed yield and and an option to convert into common when it suits me.

          1. JLM

            Well, of course, the issue is the entry price or in the VC world the valuation.

  18. giffc

    I have always had trouble stomaching the concept of participating preferred. You’ve written a very reasonable post here, Fred. I wonder how many East Coast VCs are as forward thinking as you are?

  19. HowieG

    People forget there are more losing investment than winners on average. So the winners have to pay back enough to make your whole investing ecosystem profitable. In a backass way its a winners penalty. But if your a winner you really shouldn’t care about paying the penalty because most likely you wouldn’t have such a big payoff without the VC backing.

    1. MatNYC

      Well this how the record industry picks artists to sign to labels. Anyone, know of the outcome of that business? (the music industry and live music is actually doing really well and very healthy, just not the labels). I am starting to see similar happenings with VC’s I know.

  20. Avi Deitcher

    Fred, I am impressed with two elements: first, your evolution. You yourself have mentioned how you have grown in experience from the companies with which you have dealt. Many VCs simply never evolve, despite their search for such “evolvability” as the a top character trait among entrepreneurs, whose businesses need to evolve at high speed. Second, I like your recognition that the purpose of the VC is to invest and get solid returns from building a business. Squeeze too much value/equity out, and you squeeze out founder and employee incentives, which in return has a negative feedback on the business itself.Question: is there a Laffer-style curve for VC investing? Get 0% for your investment, no return; get 100%, you kill off the goose that lays the golden eggs. Optimal range is somewhere in the middle.

  21. rhitu

    A very interesting read – thanks. I suppose it was the valuation disconnect between VCs and entrepreneurs in Q4 last year that led to the 2x-3x participating preferreds in term sheets last year. waiting to see the terms for Q1 2010.

  22. Dave Broadwin

    Glad to hear that your view of participating preferred is evolving — in the right direction. What you don’t mention is the inverse of the entrepreneur who wants to sell early — the VC who wants to sell early. I have had a number of clients situations in which the VC is motivated to sell at prices below where the entrepreneur is eager to sell. In each such case, there has been a full participation and in each such case, there has developed significant and long lasting ill will (not to mention significant disappointment for the entreprenuer because these companies have all been sold). Participating preferreds are one of the best examples of places where the interests of VCs and entrepreneurs can diverge with bad consequences for one or the other.

  23. George A.

    Pascal, you are probably talking about multiple liquidation preference. In such a case, 1x is the standard multiple. back in the day when vc money was very tight, vc’s would command a 2-3x multiple preference. in this scenario, they ask for 3x return on their investment before common receives ANY portion of the proceeds. This is pretty hardline and is really only reserved for complicated transactions where there is an ugly cap structure prior to the new investment.Multiple LP is very different than what FW is talking about, he is talking about the threshold where the participation right goes away entirely. In his scenario, he takes his preference out first, then participates pro rata on the basis of common ownership, so after 1x, all underlying common is participating. But, when the sum total of his proceeds equals 3x, his double dip goes away.I dislike PP, it sets up a precedent for future rounds and can bury common after you get thru a c round and all investors have pp. Additionally, it creates a dead space in valuation, where VC’s are indifferent within a band as to how much they receive. This goes against the notion of aligned interests. While most of the time this doesn’t happen, it can and that always felt bothersome to me.

  24. George A.

    Fred, since you are showing cards, can I ask your rake-rate accretion dividend rate?

  25. Andrew

    I buzzed through the comments quickly, but i don’t think anyone addressed the fact that participating preferred is actually bad for the early-stage investor in any relatively capital intensive deal b/c all it does is subsidize the returns of the mid- to late-stage guys, who invariably wind up on top of the preference stack. If you’re the new money in on a Series C-E, and you’re at the top of the liq pref stack with 1x full participation, you have 0 risk in the deal (b/c you’re going to get paid back first and so, unless the company craps out, you’ll at least get your money back). Further, for the early-stage guy, the true upside is in ownership – indeed, if all the early-stage guy/gal is doing is generating returns that are mostly liq pref, he/she won’t be in business very long. Given the early-stage guys/gals are (or should be) swinging for the fences, it’s going to be the IPO or big M&A that’s going to be generating most of the returns (concentrated in the early-stage guy’s/gal’s ownership). So, net, participation is going to be bad in general unless you’re selling companies at low valuations, but then you’re aren’t really performing as the early-stage guy/gal and your LPs won’t be investing in you very long.I won’t go into how participating preferred is also bad for deal-flow, as the early-stage guy, but there’s also a marketing element to this that investors need to keep in mind…

  26. Mark Essel

    Tereza hooks us up with the sweetest links. What an awesome idea that I failed to know about.Go go AVC network startup info!Where’s a good place to find a starting lead list for angel investors? Love the idea of mass syndication, but want to make sure our alpha is up and people are using it before pursuing external funding.

  27. ShanaC

    The better question- why is no lead emerging?

  28. Mat NYC

    When I was on the board for TriState ventures (angel investing group tied to many nyc vc’s) in the 90’s. We always did a mass syndication deal of the angels with $25k min to particpate. Usually the deals that came in already had some money from a friend or board member of the group.This was a cheap and easy approach to angel investing. I tend to get irritated with need to always find a lead. If you don’t want to invest on the company merit don’t invest otherwise sack up.This is risk based investing not a money market fund or CD.

  29. Jared McKiernan

    Mark, I think AngelList, if you haven’t seen it yet, might answer your question…How’s the project going by the way? I’m interested in helping out however possible, so i’d love to hear where you guys are- found it interesting to read some of your older blog posts and look at the iteration over time.

  30. Mark Essel

    Thanks for the link and your support Jared!We’re working the interface for the feed browsing page, how to find people’s feeds easily and the organizer page. The backend has been mostly done for a few weeks.

  31. Tereza

    I think in the seed round, in smaller increments, it’s not unusual.

  32. Tereza

    Mark thanks for the props and Jared thanks for the link.Go, team!:)