What's Left To Say About Participating Preferred Stock?
Man has Venture Blogging come a long way since we started VentureBlog a year and a half ago. At that time, the only way that there would be robust discussion and debate about venture capital related topics in the blogsphere would be if Andrew and I took different sides of an issue and duked it out on VentureBlog. Now folks like Brad Feld from Mobius Venture Capital and Fred Wilson from Flatiron Partners are discussing and debating VC issues of real interest and import. While Venture Capital still remains quite individualistic and, at times, enigmatic, VC bloggers have gone a long way to help demystify what has for years been a bit of a black art.
It struck me just how much information was being shared these days as I read a set of posts about Participating Preferred Stock by Brad and Fred. While there are real world implications to decisions made by VC's and entrepreneurs about Participating Preferred Stock, this is still a pretty esoteric topic. As recently as a year ago, the posts about venture financings were pretty rudimentary (here's what Joi was talking about, and here was my effort to just put the terms in context). Brad and Kevin Laws (at VentureBlog) upped the anti with deeper analysis of Preferred Stock. And now there is a debate raging online about the use and appropriateness of Participation in Preferred Stock. The real debate, mind you, is in the comments of Brad's and Kevin's pieces (we VC's are far too gentle on one another but entrepreneurs are more than willing to call BS when they see it).
For what it's worth, here are my two cents on the topic of Participating Preferred Stock. As an initial matter, If I learned anything from being company and investors counsel on hundreds of millions of dollars in venture financings, it is that you can not say anything unequivocally about the appropriateness of a particular finance term. Any term can make sense under the right circumstances. After all, venture financings take place in a market and therefore terms are driven by assessments of risk vs. reward, price vs. value, and, above all else, competition. Moreover, venture finance terms are strictly a matter of contract. Anything you can think of can be put down in writing and implemented in a contract. Thus, most new venture finance terms have emerged over time as the result of an investor's or entrepreneur's past experience (and, I dare say, it is usually negative past experiences that drive the creation of new terms). Trust me, we VC's aren't sitting around at night trying to concoct creative new finance terms that will disadvantage entrepreneurs. But we certainly are trying to learn from past experience.
That said, I am not a big believer in Participating Preferred Stock. Does it have it's time and place? Undoubtedly. But as a matter of course, I believe that the simpler the terms the better. One of the things that strongly appeals to me about being an early stage venture investor is that after I have financed a company, my interests are almost entirely aligned with those of the entrepreneurs I have backed. I like that because company building should be a collaborative process and when an entrepreneur's and investor's interests aren't aligned, unproductive tensions inevitably arise between the two. Not surprisingly, Participating Preferred can cause such tension because it assures that no matter how successful a company is, if the company is acquired (rather than going public), the investors will necessarily make more money per share than the entrepreneurs (and while a cap on the total amount of preference may solve half this problem, it still creates a class of mergers in which the venture investors will do better than the entrepreneurs). I want entrepreneurs to make decisions based upon what's best for the company and all the shareholders, not based upon how it differentially impacts the common and preferred holders.
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Participating Preferred I think is somewhat like leasing a car. There's nothing wrong with leasing a car and it has some benefits but leasing can really be a bad deal for the ignorant. Participating preferred allows VCs to give founders a valuation that appears higher than it in fact is - kind of like the low monthly payment on a car lease vs. a purchase. Like leasing, it can leave a bitter taste in your mouth at the end of the deal; in one case, a merger/sale where the investors take home a lot more per share that the founders, the other where large fees and per mile charges upset the lessee when he turns in the car. But if you are sophisticated, participating preferred can be a way for founders and VCs to split the difference on an issue of how fast / how successful a company will be. If the founders sell for a higher price than the preferences clear at (assuming there is a cap) then perhaps they got a slightly better valuation that otherwise. But in my experience, like leasing a car, most people and most times people will come out better sticking to the straight and simple deal.
I agree that the effect of the "participation" is not readily understood by many entrepreneurs. More to your point (and great analogy on the car leasing model), it is definitely not something many quality mid-level job seekers would be sophisticated enough to factor into the expected value calculation of their stock option grant. In my experience on the East Coast, many non-CxO level employees do not even understand the concept of preference.
Participation is simply a “trick of the trade” and is a moving part in a complex negotiation. I do not agree that it is necessarily all bad for companies as it allows VCs to give (if used as intended) more upside potential in the form of a higher pre-money. That said, it should send a signal to an entrepreneur that the VC is “hedging” the downside risk of the investment and is not swinging for the fences on the deal.
I recently received a participation term in trade for a higher valuation under a recap situation. I accepted it as the chance for a big win was far outweighed by the prospect of small win/asset sale. The higher valuation also helped to not completely wash out the existing common that contained my (recently converted) old preferred shares.
Any thoughts on a senior management carve-out pools? This “trick” lessens the effect of participation as it pays certain (decision making) members of the team a fixed percentage of an acquisition pari passu with the participating preferred. I believe the deal is somewhat backhanded to the other employees (who are made even more subordinate), but is sometimes necessary to get critical persons on board with the deal. I guess no deal will ever be completely fair to everyone….
(As a side note, I strongly believe CEOs should generally do a better job explaining all aspects of a VC deal to their employees in order for the economics to be more transparent.)