Frank Demmler's Site
Once upon a time an aspiring small businessperson needed some money to start his business. Through a circuitous route he found himself in front of the owner of some capital.
After explaining his plight, the small businessperson asked the capitalist for a loan. The capitalist replied, “While I find your concept intriguing, there is too much risk associated with it and I couldn’t possibly lend you the money. If I were to assume this much risk, I would need an equity stake that I could sell in the future.”
“Well, I would consider selling you some common stock,” responded the aspirant.
“That’s fine for you, but I need some additional consideration, some kind of preference, in the event you hit less than a home run,” observed the moneyman. “After all, I am trying to achieve an appropriate return on my investment, while you are an enterprising young man, an entrepreneur, if I might coin a phrase, trying to change the world.”
“You, sir, are a predatory vulture,” yelped the youngster.
“I prefer to think of it as being venturesome,” countered the investor. “If you want my money, I need to get preferred stock.”
And thus the lexicon of early stage business added “entrepreneur,” “venture capital,” and “preferred stock” to its dictionary.
The preceding fiction notwithstanding, preferred stock is the coin of the realm of virtually all institutional, and many private, investors. It is materially different than common stock in many important respects. Some of the terms and characteristics of preferred stock have important characteristics.
The conventional definition of liquidation evokes images of “going out of business” signs and sales at heavy discounts. In the industrial world, one thinks of Chapter 7 bankruptcy. In the world of private equity, the definition is expanded to take in virtually any transaction that is agreed to that is less than the proverbial home run. It is tantamount to the investor throwing in the towel on achieving the originally conceived exit, and seeking to “liquidate” his investment.
One of the key features of preferred stock is that higher in the pecking order of who gets paid what and when in the event of a liquidation. Payroll and secured creditors, among others, have first rights to the proceeds of liquidation. Preferred stock holders come next, followed by common stock holders.
This is the amount of money the investor in preferred stock has a right to before the common stock shareholders receive any money in liquidation. It is usually phrased in the term sheet something like, “The Preferred Stock Shareholders shall receive all proceeds from the liquidation until they have received 100% of their liquidation preference.”
The dollar amount is defined in the term sheet. It often starts with the investment amount plus accrued, but unpaid dividends (often in the range of 6-10%). Then, depending upon financial market conditions and the types of deals that are being done at the time, some sort of adjustment multiple is defined and applied. These multiples can be
When preferred stock was originally created (see opening paragraph), it was intended to address the differences between the entrepreneur and the financial investor. In essence, if the financial out come was less than had been anticipate, the investor postured that he wanted the opportunity to some minimum return. What resulted was the creation of simple Convertible Preferred Stock.
In its infancy, preferred stock was an either-or proposition for the investor. Calculate the liquidation preference, calculate the value of the common stock if converted, and pick the one that is to the investor’s greater benefit.
The logic is straightforward and the justification appears to be reasonable.
After a period of time, someone came up with the idea of Participating Convertible Preferred Stock. Its key feature was that the investor got the liquidation preference first, AND then participated in the distributions on an as-converted basis. The investors justify this on the basis of locking in as a good a return as possible in a less-than-desirable outcome. Entrepreneurs often take umbrage at this and consider it to be double dipping.
This is a prime example of the Golden Rule: He who has the gold rules. Without negotiating leverage, if the investor seeks participating preferred, then that’s likely to be part of their investment style, and it’s unlikely that they will be willing to negotiate this feature.
If the company sells shares at some future date at a share price less than what the investor paid, the investor wants anti-dilution protection.
The harshest form of protection from the entrepreneur’s perspective is full-ratchet. It says that the investor gets rights to that number of shares as if he had paid the lower price. If he paid $2.00 per share, and subsequent shares were sold for $1.00, his number of shares would double to compensate for this transaction.
Weighted-average is less painful. It takes the share base of the company into consideration, they reducing the overall impact. For those of you who are interested, I “borrowed” the following language from the documents one of the deals with which I was involved.
“Adjustment of Conversion Price Upon Issuance of Additional Shares of Common Stock. In the event that at any time or from time to time after the Original Issue Date for any series of Preferred Stock the Corporation shall issue Additional Shares of Common Stock (including, without limitation, Additional Shares of Common Stock deemed to be issued pursuant to Subsection 2(e)(iii)(1) but excluding Additional Shares of Common Stock deemed to be issued pursuant to Subsection 2(e)(iii)(2), which event is dealt with in Subsection 2(e)(vi)(1)), without consideration or for a consideration per share less than the Conversion Price of such series of Preferred Stock in effect on the date of and immediately prior to such issue, then and in such event, such Conversion Price of such series of Preferred Stock shall be reduced, concurrently with such issue, to a price (calculated to the nearest one tenth of one cent) determined in accordance with the following formula:
(P1) (Q1) + (P2) (Q2)
NCP = ---‑‑‑‑‑‑‑‑‑‑‑‑‑---------‑-
Q1 + Q2
NCP = New Series A Conversion Price or Series B Conversion Price, as applicable
P1 = Series A Conversion Price or Series B Conversion Price, as applicable, in effect immediately prior to new issue;
Q1 = Number of shares of Common Stock outstanding, or deemed to be outstanding as set forth below, immediately prior to such issue;
P2 = Weighted average price per share received by the Corporation upon such issue;
Q2 = Number of shares of Common Stock issued, or deemed to have been issued, in the subject transaction;
provided that for the purpose of this Subsection 2(e)(iv), all shares of Common Stock issuable upon conversion of shares of Preferred Stock outstanding immediately prior to such issue shall be deemed to be outstanding, and immediately after any Additional Shares of Common Stock are deemed issued pursuant to Subsection 2(e)(iii), such Additional Shares of Common Stock shall be deemed to be outstanding.”
I often hear entrepreneurs say, “I won’t give up control,” or “I’m willing to consider any deal as long as I retain 51%.” For a plain, vanilla company, that makes sense and is meaningful. But a company that brings in sophisticated private equity is no longer “simple,” at least in a legal sense. To a large degree, control and percentage of ownership become separate issues. Let me cite two examples.
One of the features of preferred stock will be a series of provisions that require that the preferred stock needs to approve before the company can do certain things. Let me rephrase that, regardless of how much equity the preferred stock shareholders own, they have veto power over certain company actions, typically including, but not limited to, liquidation, alteration of the preferred stock, issuance of any class of preferred stock superior to the existing preferred stock and restrictions on debt that the company can take on.
Similarly, as part of the Preferred Stock transaction there will be agreement to the structure of the board and a Shareholders Agreement will be crafted whereby all shareholders have to vote for members of the board in the proscribed manner, regardless of relative equity positions.
Once a company goes down this path, the issue of “control” becomes complicated and not intuitively obvious, particularly to first-time entrepreneurs.
Next week we’ll look at the potential consequences of some of these features of preferred stock.