As a startup founder gearing up for a fundraising round, it’s crucial to familiarize yourself with the different types of shares that venture capital investors may request in exchange for their investment. One such type of share is the participating preference share. In this blog, we will explore the concept of participating preference shares, their benefits and drawbacks, and their potential impact on your startup.
What Are Participating Preference Shares?
Participating preference shares are a type of preference share that offers investors not only a fixed dividend rate and liquidation preference but also the opportunity to participate in any additional profits or proceeds after the initial preferences have been satisfied. In other words, these shares allow investors to “double-dip,” receiving both their preference dividends and liquidation preference and sharing the remaining profits with common shareholders.
Preference shares explained to a teenager
Participating Preference Shares are a type of ownership in a company, like owning a special kind of stock. Imagine you and your friends create a cool new app, and you need money to grow your business. You find investors who are willing to give you money, but they want something in return. These investors ask for Participating Preference Shares, which give them extra benefits compared to regular shares.
When your app becomes really successful and you sell the company or go public, the investors with Participating Preference Shares get their money back first, plus any extra money they were promised, like a bonus. After that, they also get to share the remaining money with everyone else who owns shares, just like they had regular shares.
So, these special shares give investors more security and a better chance to make money. As a startup founder, you need to balance giving these benefits to investors while keeping enough rewards for yourself and your team.
How do Participating Preference Shares actually impact founders?
If you grow like weeds and have a huge exit, it’s likely that you don’t care about preference shares (unless they are participating preferred).
If you have ‘clean’ preference shares, they just convert into common shares at your exit and you might not even be aware.
Where preference shares can flark you is when they are fancy and you don’t sell for much. In that case you might end up with nothing. Yes, sir. Nada. Zilch.
Why? Check out liquidation preferences.
- Dilution of returns: Participating preference shares can significantly dilute the returns for common shareholders, including founders and employees, as investors receive a larger share of the profits.
- Complexity: The presence of participating preference shares can add complexity to the company’s capital structure and make future fundraising rounds more challenging.
- Negotiation challenges: The terms associated with participating preference shares can be difficult to negotiate, potentially leading to prolonged fundraising rounds and friction between founders and investors.
Why do founders and staff get common shares and not Participating Preference Shares?
Investors almost always have preference shares, or if they are investing in a convertible note, will convert their debt note into preference shares at the next qualified financing round. Cumulative Participating Preference Shares are not super common unless you are at a later stage and your startup is not performing well.
See my blog on preference shares.
How are Participating Preference Shares different to common shares?
I’ve set out the key terms in a table.
|Feature||Participating Preference Shares||Common Shares|
|Dividends||Fixed dividend rate, paid before common shareholders||Discretionary paid after preference shares|
|Liquidation Preference||Initial investment + accrued dividends, then participate in remaining proceeds||Receive proceeds after preference shareholders|
|Voting Rights||May have voting rights on specific matters and/or board representation||Typically have voting rights on various matters|
|Conversion to Common Shares||Can be converted to common shares (at the investor’s discretion)||N/A|
|Seniority in Capital Structure||Higher priority than common shares in the event of liquidation||Lower priority than preference shares|
|Upside Potential||Benefit from both liquidation preference and participation in remaining proceeds||Participation in remaining proceeds only|
Benefits of Participating Preference Shares for Investors
- Enhanced returns: Participating preference shares can increase the potential returns for investors, as they receive the fixed dividend and liquidation preference and also participate in any excess profits.
- Downside protection: The liquidation preference feature provides a safety net for investors in case the company is sold at a lower valuation or goes bankrupt.
- Control: Participating preference shares may come with certain protective provisions or voting rights, giving investors more control over the company’s decision-making process.
Do investors always want to have Participating Preference Shares?
Venture capital investors do not always want to have participating preference shares when investing in startup companies. The choice to seek participating preference shares depends on the investor’s preferences, negotiation dynamics, and the specific circumstances of the startup.
Here are a few reasons why venture capital investors might not always opt for participating preference shares:
- Stage of the startup: Early-stage startups might have less complex capital structures, making non-participating preference shares or even common shares more appealing for investors who are looking to minimize complexity.
- Risk-reward balance: Some investors may view the potential returns from non-participating preference shares as sufficient and may not see the need to request participating preference shares, which can lead to more complex negotiations and higher valuations.
- Negotiation dynamics: During the fundraising process, the relative bargaining power of the startup and the investor can influence the terms of the investment. If a startup is in high demand or has strong growth prospects, founders may be able to negotiate more favorable terms, such as non-participating preference shares or common shares.
- Investor philosophy: Certain investors may have a philosophical preference for simpler investment structures and may prioritize establishing strong, collaborative relationships with founders over extracting the maximum return from their investment.
- Industry trends and competition: The prevalence of participating preference shares may vary by industry, geography, or fundraising environment. In competitive markets with numerous investors, startups may be able to secure more favorable terms.
In summary, while participating preference shares can offer enhanced returns to venture capital investors, they are not universally sought after.
What is an example of Participating Preference Shares in startup investments?
Let’s consider a hypothetical startup investment scenario to illustrate how participating preference shares work.
Suppose Startup ABC raises $2 million in Series A funding from Venture Capital Firm XYZ. In exchange for their investment, XYZ receives participating preference shares with an 8% annual dividend and a 1x liquidation preference.
Here’s how the participating preference shares would work in this case:
- Dividend rate: XYZ receives an 8% annual dividend on their $2 million investment, which amounts to $160,000 per year.
- Liquidation preference: If Startup ABC is sold or liquidated, XYZ would first receive their original investment of $2 million (1x liquidation preference) plus any dividends due before common shareholders receive any proceeds.
Let’s assume Startup ABC is sold for $10 million after three years.
- Participating feature: After receiving their liquidation preference and dividends, XYZ would then participate in the remaining proceeds with common shareholders. In our example, after the liquidation preference ($2 million), there’s $8 million left to be distributed among shareholders.
Assuming that XYZ holds 20% of the shares (including their participating preference shares) and common shareholders hold 80%, XYZ would receive an additional 20% x $8 million = $1.6 million.
- Total proceeds for XYZ: The venture capital firm would receive the liquidation preference ($2 million), any due dividends (e.g., $160,000 x 3 = $480,000), and the participating share of proceeds ($1.6 million). In this example, XYZ would receive a total of $4.08 million.
In summary, participating preference shares in a startup investment offer investors the benefit of not only receiving their preference dividends and liquidation preference but also participating in the remaining proceeds alongside common shareholders. This can result in a higher return on investment for the participating preference shareholder.
Should founders be worried about giving investors Participating Preference Shares?
You do not need to be worried about investors having preference shares and you having common. You do not ever get preference shares, and investors almost always expect to get preference shares so there’s just not point in fighting it.
What you should absolutely be worried about though are participating preferred shares though! Firstly it assumes that the investors are getting at least a 1x liquidation preference which is not fun. It also means that the investors will ‘double dip’.
What do venture capital investors mean when they say “double dip” with Participating Preference Shares?
When venture capital investors refer to a “double dip” with participating preference shares, they are talking about the dual benefits these shares provide during a startup’s exit event, such as an acquisition or a public offering. Participating preference shares allow investors to receive their initial investment back (plus any accrued dividends) and then share in the remaining proceeds with common shareholders.
The “double dip” occurs as follows:
- Liquidation Preference: First, participating preference shareholders receive their liquidation preference, which is typically the amount of their initial investment (and sometimes a multiple thereof) plus any accrued dividends. This is the first “dip” in the proceeds of the exit event.
- Participation in Remaining Proceeds: After receiving the liquidation preference, participating preference shareholders also participate in the remaining proceeds of the exit event alongside common shareholders, based on their ownership percentage. This is the second “dip” in the proceeds.
This dual benefit provides participating preference shareholders with a higher return on investment compared to non-participating preference or common shareholders, who only participate in the remaining proceeds after the liquidation preference has been paid out.
By offering this “double dip” structure, venture capital investors can mitigate their risk and potentially increase their returns, especially in situations where the exit valuation is lower than anticipated.
How are Participating Preference Shares valued differently to common shares in the USA with a 409a?
See my blog on preference shares.
Why do investors want Participating Preference Shares ?
To keep this blog short(er), why wouldn’t you want to have benefits with friends?
Preference shares confer additional benefits over common. It’s just that simple.
Are Participating Preference Shares debt or equity?
Participating preference shares are a form of equity when venture capital investors invest in startups. They represent an ownership stake in the company and grant the investors certain rights and preferences over common shareholders.
While participating preference shares have some characteristics that resemble debt, such as a fixed dividend rate and liquidation preference, they are not classified as debt. Debt typically involves a contractual obligation to repay borrowed money with interest, whereas participating preference shares represent an ownership stake in the company without a contractual obligation for repayment.
The key differences between debt and participating preference shares include:
- Repayment: Debt requires repayment of the principal amount plus interest while participating preference shares do not have a repayment obligation.
- Interest vs. Dividends: Debt has interest payments while participating preference shares have dividend payments. Interest payments are tax-deductible for the company, while dividend payments are not.
- Ownership: Debt does not grant ownership in the company while participating preference shares represent an ownership stake with specific rights and preferences.
- Voting Rights: Debt holders generally do not have voting rights in the company’s decisions, while participating preferred shareholders may have voting rights on specific matters and/or board representation, depending on the terms negotiated.
- Seniority in Capital Structure: Debt holders have a higher priority in the capital structure compared to equity holders, including preference shareholders, in the event of liquidation.
In summary, participating preference shares are a form of equity, not debt, when venture capital investors invest in startups. They offer investors specific rights and preferences over common shareholders and provide a higher return potential compared to non-participating preference or common shares.
When do venture capital investors not require Participating Preference Shares in a startup fundraise?
There are several scenarios in which venture capital investors may not require participating preference shares in a startup fundraise:
- Early-stage startups: Investors may not seek participating preference shares when investing in early-stage startups that have a simpler capital structure. In such cases, they might prefer non-participating preference shares or even common shares to keep the investment structure straightforward.
- Founder-friendly terms: When investors want to establish a strong relationship with the startup founders, they may be willing to forgo participating preference shares in favour of more founder-friendly terms, such as non-participating preference shares or common shares.
- Strong negotiation position for founders: If a startup is in high demand or has strong growth prospects, founders may have more bargaining power during negotiations, enabling them to secure more favourable investment terms like non-participating preference shares or common shares.
- Investor philosophy: Some investors have a preference for simpler investment structures and prioritize collaboration with founders over maximizing returns. In these cases, they may not require participating preference shares.
- Competitive investment environment: If there is a high level of competition among investors to invest in a startup, founders may be able to negotiate better terms, such as non-participating preference shares or common shares.
- Precedent transactions: If the startup has previously raised capital with non-participating preference shares or common shares, new investors may be willing to accept similar terms to maintain consistency with the existing capital structure.
Ultimately, the choice to seek participating preference shares or other types of shares depends on the investor’s preferences, negotiation dynamics, and the specific circumstances of the startup.
What happens if investors own Participating Preference Shares in a startup that goes bankrupt?
If a startup goes bankrupt and its assets are liquidated, the proceeds from the sale of those assets are distributed among the company’s creditors and shareholders in a specific order of priority. Investors who own participating preference shares have a higher priority in the capital structure compared to common shareholders, but they come after any outstanding debts and other liabilities. Here’s what happens in such a scenario:
- Payment of debts and other liabilities: Before any proceeds are distributed to shareholders, the startup’s outstanding debts, taxes, employee wages, and other liabilities must be settled. Secured creditors are paid first, followed by unsecured creditors, and any other priority claims.
- Liquidation preference for participating preference shareholders: After settling debts and liabilities, participating preference shareholders receive their liquidation preference, which typically equals the amount of their initial investment plus any accrued and unpaid dividends. In some cases, the liquidation preference might include a multiple of the initial investment.
- Participation in remaining proceeds: If there are any remaining proceeds after paying the liquidation preference to participating preference shareholders, they will also participate in the distribution of these proceeds alongside common shareholders, based on their ownership percentage.
- Distribution to common shareholders: If any proceeds are left after settling the claims of participating preference shareholders, the remaining amount is distributed among common shareholders.
It is important to note that in cases where the startup’s assets do not generate enough proceeds to cover its debts and liabilities, participating preference shareholders may not receive any payment. Similarly, if the proceeds are insufficient to cover both the liquidation preference and the remaining proceeds participation, participating preference shareholders may receive only a partial payment or none at all.
In summary, while participating preference shareholders have a higher priority than common shareholders in a bankruptcy scenario, they are still at risk of not receiving their full investment back if the startup’s assets do not generate enough proceeds to cover all claims.
How to Approach Participating Preference Shares in a Fundraising Round
As a startup founder, it’s essential to understand the implications of participating preferred shares on your company and carefully consider whether they align with your long-term goals. Here are a few tips for navigating the fundraising process:
- Assess the trade-offs: Evaluate the benefits and drawbacks of participating preferred shares in the context of your company’s specific circumstances. Consider the potential impact on your ownership stake, dilution, and future fundraising rounds.
- Research investor preferences: Understand the preferences and expectations of your target investors. Some may be more amenable to non-participating preference shares or common shares, depending on the stage and risk profile of your startup.
- Be prepared to negotiate: The terms associated with participating preference shares are subject to negotiation. Work with legal counsel and financial advisors to develop a strategy that protects your interests while accommodating investor requirements.
- Communicate openly: Maintain open lines of communication with investors and be transparent about your concerns and expectations. A collaborative approach can help build trust and pave the way for a successful fundraising round.
Participating preference shares can be a double-edged sword for startup founders, offering the potential for increased investment while also diluting returns for common shareholders. By understanding the nuances of participating preference shares and being prepared to negotiate, you can make informed decisions that best serve the long-term interests of your startup and its stakeholders.
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