Preferred Shares: How They Can Affect Your Employees

Preferred shares are a staple in venture capital deals for startups. They are unique equity vehicles in the fact they represent ownership in a company but come with different characteristics as compared to common shares. Preferred shares often include fixed dividend payments and have priority over common shares in terms of dividend payments and liquidation proceeds and are not required to but can carry voting rights. This makes them a unique blend of equity and debt-like features, appealing to investors who seek income generation and lower risk as compared to common stock.

However, as founders and equity professionals, it’s important to know what affect preferred shares can have on your common holders, especially in this current climate where investor friendly deals have become more prominent than in times past. In this article, we’ll be enlightening you on the minutia of preferred shares and how they can affect the value received by you and your employees in the case of a liquidation event. 

The Nature of Preferred Shares

Underneath all the bells and whistles of preferred shares is the underlying desire for investors to have a safety net when funding startups that are more often that naught seen as rather risky investments. 

Preferred shares satisfy this “safety net’ desire of investors by assuring them that in the case of a liquidation event, they stand first in line to reclaim their investment over common holders. This means that if Company XYZ was offered to be acquired for $3 million and investors held preferred shares based off a $2 million investment with a 1x liquidation preference, then the investors would receive their $2 million investment back first before common holders ever saw a cent from the acquisition.  

In this scenario, because the terms of the preferred shares only called for a 1x liquidation preference, $2 million of the $3 million acquisition was paid out to investors first, leaving $1 million to be distributed among common holders. 

Liquidation Preference Overhang

As evidence by the example recently discussed, preferred shares in essence create what is sometimes referred to as “ liquidation preference overhang”. This term refers to the scenario where preferred shareholders have the right to receive their initial investment back before any proceeds from a liquidation event can be distributed to common shareholders. 

This situation can lead to a significant portion, if not all, of the liquidation proceeds being allocated to preferred shareholders, potentially leaving little to no remaining assets for common shareholders despite their ownership percentage in the company, thus negatively impacting your employees, who not only spent time growing the company, but may have even used their own capital to exercise their awards.  

Investor Friendly Terms

In Q1 and Q2 of 2023, Peter Walker, the Head of Insights at Carta, released a report showing that during this time frame, investor friendly deals had seen a sharp rise. Investors were now getting more deals done where liquidation preferences contained multipliers greater than the standard 1x and even more shocking was the increase seen in participating preferred deals. 

Example 1: Liquidation Preferences 1x vs 3x Multipliers

Scenario:

• A company is sold for $60 million.
• Preferred shareholders hold $30 million in preferred stock.

1x Liquidation Preference:

• Preferred shareholders receive 1x their investment ($30 million).
• Remaining $30 million is distributed to common shareholders.

3x Liquidation Preference Without a Cap:

• Preferred shareholders receive 3x their investment ($90 million), which exceeds the sale price.
• Common shareholders receive nothing.

Impact:

• With a 3x liquidation preference multiplier, preferred shareholders claim all the exit proceeds, leaving nothing for common shareholders.

Definitions

Liquidation Preference

• A clause in preferred stock terms.
• Dictates payout order and amount during a company's sale, merger, or liquidation.
• Ensures preferred shareholders are paid back their investment before common shareholders.

Liquidation Multiplier

• Enhances the liquidation preference.
• Specifies a multiple of the initial investment for preferred shareholders.
• For example, a 2x multiplier means preferred shareholders receive twice their investment before any payout to common shareholders.

Cap on Liquidation Preference

• A limit set on the amount preferred shareholders can receive.
• Expressed as a percentage of exit proceeds or a fixed amount.
• Ensures that, beyond this cap, remaining proceeds are distributed to common shareholders.

Example 2: Participating Preferred

Scenario

• The company sells for $45 million.
• Preferred shareholders have $40 million in preferred stock with a 1x liquidation preference and full participation rights.

Non-Participating Preference:

• Preferred shareholders receive 1x their investment ($40 million).
• Remaining $5 million is distributed to common shareholders.

Participating Preference:

• Preferred shareholders receive 1x their investment ($40 million) plus their proportional share of the remaining $5 million.
• Assuming preferred shareholders own 80% of the company, they get an additional $4 million (80% of $5 million).
• Only $1 million is left for common shareholders.

Impact:

• Participation rights, combined with a relatively low exit valuation based on investment, results in preferred shareholders receiving almost the entire sale proceeds, leaving a minimal amount for common shareholders.

Definitions

Participating Preferred Stock

• Allows shareholders to receive their liquidation preference and then participate in additional profits.

Liquidation Preference Payout

• Initially, shareholders receive their liquidation preference (e.g., 1x their investment).
• This payment is made before any distributions to common shareholders.

Participation in Additional Profits

• After receiving the liquidation preference, participating preferred shareholders also get a share of any remaining profits.
• This share is usually proportional to their ownership percentage.

Impact on Common Shareholders

• Can significantly reduce the amount available to common shareholders in a sale or liquidation.
• Especially impactful in scenarios where the company is sold at a valuation close to or only slightly above the total investment amount.

Conclusion

The takeaway is clear: preferred shares are essential tools in venture capital, but they wield a significant influence over the financial fate of common shareholders in exit scenarios. For this reason, it's crucial for founders and equity professionals to grasp the full implications of these financial instruments, because while preferred shares offer investors a cushion in the high-stakes startup environment, they can also lead to disproportionate outcomes for founders and employees, who have often times poured their heart and soul into building the company.

For additional resources on equity compensation as it relates to private and startup companies please refer to the NASPP website where we have a plethora of resources, including our Equity Compensation Fundamentals - Private Companies course where industry leaders delve into this subject in great detail!