Our bullpen of advisors continued with their Venture School lesson, asking about what we are seeing in valuations: are they rising? Is it a bubble? etc. Sure, we have seen some froth, but mostly coming out of the untamed world of uncapped converts and unchained angels. Most of the deals being referred to us by institutional super-angels are following a pattern set several years ago: these funds are giving A round pre-money valuations on smaller money in.
This is not as simple as what is the stated pre-money, because terms matter, in particular the nefarious Participating Preferred. It depresses the effective pre-money, but disguises that fact. The VCs have a negotiating advantage, the more complex they make the deal.
When the “book” on venture finance was first written (literally – there is a tremendous resource from the ’80s called Venture Capital and Public Offering Negotiation that has been updated over the years), preferred stock was straightforward: the investors could choose to take their money back, or convert to common and participate in the gain with the common shareholders. Simplified example: your VC invest $5m for half the company (“5 on 5 pre”). Here are two contrasting outcomes:
- Company sells for $6M – VC takes their $5m back, management gets the remaining $1m
- Company sells for $100m – VC converts to common, gets $50m, management gets $50m
This balanced incentives, since in a poor outcome the investors got their money back, and in a good outcome, the gains split as agreed in relative ownership. The preferred stock was also valued more than common, giving management a “preferred stock umbrella” allowing them to price options much lower. Without it, options have to be priced at the investors’ price. One of the big mistakes made in untamed friends & family deals is to give investors common stock; this then makes options equally expensive. With preferred stock, the options can remain cheap even after several rounds of venture investment at ever higher valuations.
When the euphoric bubble of the 1980s faded, a different sort of preferred began creeping into deals, particularly from East Coast venture firms: Participating Preferred. After the 2000 bubble burst, the West Coast firms began piling on, too. With participating preferred, the VCs get paid their money back plus get to share (“participate”) in the balance along with common. Here is our simple example again:
- Company sells for $6M – VC gets $5m plus half the remaining $1m; management gets $500k
- Company sells for $100m – VC gets $5m plus half the remaining $95m; management gets $47.5m
This isn’t so bad with small money in and big outcomes, but after the A round will come the B, C and D rounds, and if the A get participating, all the rest will insist upon it, too. Consider what happens if $50m is layered into the company, and the VCs accumulate 70% ownership:
- Company sells for $6m – The D round likely takes it all
- Company sells for $100m – VCs get the first $50m and 70% of the rest; management gets $15m
As the A round funds quickly figured out, pushing for participating preferred in the A round shafted them later, as (in the simple example) $45m of preference was layered on top of their interest. More recently, A round firms have backed off participating preferred.
As with all clever financial instruments, it has its place but can be abused. Normally participating preferred is useful in a later round at a high valuation. It protects the later stage investors for a poor outcome. There are circumstances where a high valuation is required – for example, to avoid having to deal with anti-dilution provisions, or to avoid the stigma of a down round – and participating preferred keeps the stock price high while effectively lowering the real valuation.
One way to accommodate this need is to cap the participation right. A typical cap is 2x, although during the dismal down days of 2002-04, I saw caps of 3x – 5x. Here is how it works: the VC can choose to get their money back plus the extra up to the cap; or convert to common. Let’s go back to our simple example with $50m in and a 2x cap:
- Company sells for $6m – the series D takes all (less any carveout for management, typically 10%)
- Company sells for $100m – VCs get $50m plus 70% of the rest, which is below their 2x cap; management gets $15m
- Company sells for $200m – VCs convert to common and get $140m; management gets $60m
Mathematically, there is an indifference point for VCs where below that they take the cap and above the convert. In this simple example, this would be around $121m, where the VCs get their $50m back plus participates 70/30 with common in the next $71m until they get their 2x back, for $100m total. Management would get around $21m. Interesting, there is a flat spot between $121m and $143m where the VCs get no more (since they are capped). If they converted to common they would be below $100m until the exit hits $143m (70% * $143m = $100m).
Once the cat is out of the bag on cleverness, all sorts of shenanigans emerge, such as participating at a faster pace for a while, or allowing more to go to common until they “catch up” to the preferred. Funny things can happen with a stack of different preferred with different caps & prices; a VC with a flat spot has no incentive for a higher price, whereas a VC with a “sweet spot” can make out better than their compatriots.
These complexities may help a round get done, but they make an exit overly complicated at times.
I recommend against participating preferred in early rounds, and if you have to accept it, keep it simple and make sure it is capped. This protects the VC for a poor outcome, but returns the balance for a good outcome.