Posts from Preferred stock

Liquidation Analysis (Continued)

Last week I pointed out that when your company is sold at price points around or below prices where you have financed your company then your proceeds in a sale transaction will not equal your fully diluted ownership percentage times the sale price. You will get less because some or all of the preferred shareholders will choose to take their liquidation preference instead of their percentage of the company.

And in that post last week, I promised to show you all how to model this out.

Before I do that, a couple acknowledgements. Andrew Parker and Christina Cacioppo had a hand in helping me put this liquidation model together (its the second tab in the google spreadsheet). Andrew built the original template when he was at USV and Christina modified it before sharing it with me.

One of the jobs of an analyst or an associate at a venture capital firm is building these models. They are complicated and time consuming. I took a close look at Andrew and Christina's work before creating this model. I built it from scratch (driven off the cap table model I shared a few weeks ago) and it took me a couple hours to do it. It's not a simple thing to build one of these.

I did it from scratch for a few reasons. First, I wanted it to be driven off the sample cap table and be part of that shared spreadsheet. Second, I wanted to do it slightly differently than Andrew and Christina's model. And mostly, I wanted to prove to myself that I can still do this work. I passed that final test by the way.

Ok, so with all of that out of the way, here's how you model out a liquidation scenario. First lay out the capitalization of the company. List each class of stock, how many shares there are, what the cost of that class was, what the liquidation preference of that class is, and how much of the company each class owns. You can see that work at the top of the liquidation analysis in the section called "shareholdings".

As part of that work, you need to figure out what the terms of the various classes of preferred are. You need to know if they are straight preferred or participating preferred. And you need to know if there are any dividends paid in liquidation. And you need to know if any of the classes have a liquidation mutiple (1.5x, 2x, etc). If any of those things are present, put them into the shareholdings section as well.

For the sake of this model, I assumed that all three classes of preferred (Srs A, Srs B, and Srs C) are straight preferred with no multiple or dividends. That makes all of this much simpler. I also assumed the Srs C is senior to the Series B which is senior to the Series A.

If you don't know what any of this stuff means, then I would suggest you head over to Brad Feld's awesome term sheet series and read the section on liquidation preference.

Ok, back to the model (again, its the second tab). The next thing you do is lay out across multiple columns a range of exit values (sale prices). I chose $5mm to $55mm in $5mm increments.

Then in the rows under those sale price headings, you lay out the liquidation waterfall. Start with the most senior class of stock (in this case Srs C), and figure out how much of the liquidation preference would be paid out in the specific sale price. Then figure out how much is left for the rest of the shareholder base after that class is liquidated. And then figure out how many fully diluted shares are outstanding after that class is liquidated and taken out of the cap table. And finally figure out what the value of that residual is per remaining share.

That residual value per fully diluted share number is imporant. If that number is higher than the cost per share of the next class, the next class will convert to common in a sale and will not take its liquidation preference. If that number is lower than the cost per share of the next class, the next class in the waterfall will choose to take its liquidation preference as well.

You do this work class by class until you get to the common and option holders. They do not have a liquidation preference so they simply share the remaining residual (if there is any) on the basis of how many shares they own divided by how many fully diluted shares are left in the cap table after the liquidation of various classes of preferred.

Once you have worked through the waterfall by class, you then sum up the proceeds by class of stock. There are a couple reasons you want to do this. First, you want to show how much each class is getting in each sale price scenario. But this also serves as a great check on your work. If the total proceeds of all the classes equals the sale price, your formulas are working right (that doesn't mean the model is right but it is one good check).

Finally, you should add up the proceeds for each shareholder (or major shareholder). Each major shareholder will want to see how much they are getting in the various sale price scenarios. And this is again a great check on your work.

A few final comments. First, I assumed that all of the options that are listed as "unissued" in the model cap table eventually get issued before the sale happens but that no additional options are added to the cap table. That is an unlikely scenario. Usually there are unissued options in the cap table at the time of sale and you need to take them out of the cap table before doing the liquidation analysis.

And the choice of $55mm for the final sale price was not accidental. That is the next price increment above the point where all the preferred will choose to convert to common. That scenario has every class taking their fully diluted ownership percentage of the sale price. From that point on, there is no need for a liquidation model. That is why I ended there.

Again, this is complex stuff. There are likely to be a ton of questions in the comments. And it is entirely possible that there are bugs in this model. If you find them, please point them out and I will fix them.

But as complicated as this is, it can get even more complicated. Things like participating preferred shares and dividends and multiples make this even worse. A good reason to avoid all of that when you set up your cap table!

#MBA Mondays

Liquidation Analysis

Last week we talked about the cap table and I showed an example of one in a format I like. So if you are one of the founders and you own 19.6% of the business after three rounds of venture financing and you sell the company, is it possible that you would get less than 19.6% of the proceeds on the sale? The answer is yes. Not enough founders realize this.

The reason you can sell your company and not get your fully diluted ownership percentage of the proceeds is that preferred stock holders get to choose between getting their cost back or taking their fully diluted ownership percentage of the proceeds. If any of your preferred investors choose the former, and the sale price is low enough, you will not get your full percentage of the proceeds.

The way to model this out is called a liquidation analysis. I'm on vacation right now so I haven't built the liquidation analysis (which will be a second tab in the google spreadsheet). I will do that between now and next week and we will finish this topic next monday with a demonstration of how to build a liquidation analysis.

#MBA Mondays

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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