Explanation of Key Terms in Venture Financing
Sellers of businesses are starry-eyed about valuation. They often focus on it and neglect to consider other key terms. So much so that they overlook key provisions or terms that can have a meaningful impact the amount of cash received when they sell. Below are some of the most common terms that every entrepreneur who plans to take equity investment should understand. Those interested in more detail should also read the new third edition of Venture Deals by Brad Feld. Each term is also linked to an external source for further clarity.
Common Stock – Common stock is the basic equity interest in a company. It is typically the type of stock held by founders and employees.
Preferred Stock – Preferred stock has various “preferences” over common stock. These preferences can include liquidation preferences, dividend rights, redemption rights, conversion rights and voting rights, as described in more detail below. Venture capitalists in private companies typically receive preferred stock for their investment.
“Series” of Preferred Stock – When a company raises venture capital in a preferred stock financing, it typically designates the shares of preferred stock sold in that financing with a letter. The shares sold in the first financing are usually designated “Series A”, the second “Series B”, the third “Series C” and so forth. Shares of the same series all have the same rights, but shares of different series can have very different rights.
Liquidation Preference – “Liquidation preference” refers to the dollar amount that a holder of a series of preferred stock will receive prior to holders of common stock in the event that the company is sold. It is usually expressed as a multiple of the amount invested. (E.g. 1x or 2x).
Senior Liquidation Preference – A series of preferred stock has a “senior” liquidation preference when it is entitled to receive its liquidation preference before another series of preferred stock. (All series of preferred stock will, of course, be “senior” to the common stock simply by virtue of having a liquidation preference.)
Participation – Preferred stock is said to have “participation” rights when, after the holders of preferred stock receive their full liquidation preference amount, they are then entitled to share with the holders of common stock in the remaining amount being paid for the company. For example, if the company is sold for $200 million, the preferred stock has a liquidation preference of $30 million and the preferred stock represents 40% of the total number of outstanding shares of the company, then the $200 million would be distributed among stockholders as follows:
(1) – First $30 million – Paid to holders of preferred stock per their liquidation preference.
(2) – Remaining $170 million:
- Preferred stock holders receive their 40% pro rata share ($68 million) per their participation rights.
- Common stock holders receive remaining 60% ($102 million).
Totals: Preferred stock holders – $98 million
Common stock holders – $102 million
Capped Participation – Participation rights are described as “capped” when the participation rights of the preferred stock are limited so that the preferred stock stops participating in the proceeds of a sale (or other distribution) after it has received back a pre-determined dollar amount (caps typically range from three to five times the original amount invested).
Building on the previous example, if the participation rights of the preferred stock were capped at a 3x multiple of their liquidation preference amount (which 3x includes the amount of liquidation preference), then the result would be that the preferred stock would receive only an additional $60 million in participation in step (2) above. Thus, the total amount received by the holders of preferred stock would be $90 million (down from $98 million without a cap) and the amount received by the holders of common stock would increase to $110 million (up from $102 million).
Preferred Stock Conversion: The rights of preferred stock will allow the holder to analyze whether it makes more sense to receive distributions according to the preferred terms, or, if the economics make more sense, to forgo all preferred rights and convert to common – typically at a 1 to 1 ratio. Note: If the price paid for the company in this example were substantially higher (e.g., $275 million) then the holders of preferred stock would convert to common stock (thereby giving up their liquidation preference) in order to eliminate the 3x cap, because 40% of $275 million equals $110 million, which is $12 million more than the preferred would receive if they did not convert and were subject to the 3x cap.
Anti-dilution Provisions – Anti-dilution provisions retroactively reduce the per share purchase price of preferred stock if the company sells stock in the future at a lower prices. This is affected by increasing the conversion rate of the preferred (move from 1 to 1 to something more favorable) and accordingly increasing the number of shares of common stock into which a share of preferred stock converts. There are two main types of anti-dilution protection: weighted average anti-dilution protection and ratchet anti-dilution protection. Weighted average is more common recently and is less punitive. The fundamental difference is as follows: ratchet anti-dilution will fully adjust the preferred conversion rate to the new price regardless of how few shares are sold at the new price, whereas weighted average will adjust toward the new price, but if very few new shares are sold, the impact will be lessened.
Dave Chase is Managing Partner at Advanced CFO. At Advanced CFO, we provide fractional accounting and financial services. We have served more than 800 clients. They see us as their strategic, outsourced CFO. We provide CEOs with critical information so they can make key decisions with confidence. We do this by leveraging our experience and technology to provide actionable information and results. For more information, click here.