Preferred Shares in PE/VC Investments

October 2019

Choice of Security

When venture capitalists decide to invest in a company, they face a series of important choices about how to structure the investment. One of the most crucial decisions is selecting the type of security to hold—Common Stock, Preferred Stock, or Notes. Each option carries its own set of advantages and implications, affecting both the investor and the company in different ways.

At its core, equity represents ownership in a company, typically in the form of shares. In venture capital, the two most common types of equity are Common Shares and Preferred Shares. While they may seem similar on the surface, these securities come with key differences that impact financial returns, shareholder rights, and control over the company’s direction.

Common vs. Preferred Shares

Common Shares are usually held by a company’s founders and employees. These shareholders have full voting rights and are entitled to dividends and liquidation proceeds—but only after all other claims have been settled. Unlike Preferred Shares, Common Shares don’t come with special protections like liquidation preferences or enhanced voting privileges, which can make them a riskier choice for investors.

Preferred Shares, on the other hand, are the go-to option for venture capitalists because they offer greater protections and control. Investors with Preferred Shares have priority over Common Shareholders when it comes to dividends and liquidation proceeds, reducing their downside risk. These shares often come with additional rights, such as:

• Redemption rights, allowing investors to sell shares back to the company under certain conditions.

• Anti-dilution protection, which adjusts conversion ratios to safeguard investors if the company’s valuation drops.

• Enhanced voting rights, ensuring investors have a stronger voice in major company decisions.

• Drag-along and co-sale provisions, which give investors the option to sell their shares alongside founders during an acquisition.

• Rights of first refusal, allowing investors to purchase newly issued shares before others.

Key Differences and Considerations

Preferred Shares are typically issued to investors during funding rounds, striking a balance between income generation and capital appreciation. They enjoy higher claims on a company’s assets and earnings and often come with higher dividend rates. However, some Preferred Shares lack voting rights, meaning investors may have limited influence over company decisions. They can also be structured with liquidation preferences—often 2x or 3x the original investment—to provide additional security.

In contrast, Common Shares offer direct ownership and voting power, giving shareholders a say in how the company is run. However, they come with more risk: dividends aren’t guaranteed, and in a liquidation event, Common Shareholders only get paid after all other obligations have been met. They also tend to experience greater price fluctuations, making them a more volatile investment.

Choosing the Right Share Structure

Deciding between Common and Preferred Shares depends on a company’s long-term strategy and fundraising goals. Venture capitalists tend to favor Preferred Shares because they provide protections and financial incentives that help attract investors. Meanwhile, Common Shares are often used to incentivize employees and allow founders to retain control over the company.

One important factor in structuring equity is the pricing of Common Stock. Founders and key employees typically acquire Common Shares at a much lower price than later investors. As a company grows and its valuation increases, this gap can create tax complications. To navigate these issues, investors often opt for senior securities, such as Preferred Shares, instead of Common Stock. This approach helps them manage the complexities of equity compensation while maintaining financial flexibility.

Ultimately, the choice between Common and Preferred Shares isn’t just about ownership—it’s about aligning incentives, managing risk, and setting a company up for long-term success.

Basics of Preferred Stock

Venture capital firms typically purchase Preferred Stock rather than Common Stock due to the additional rights and privileges it offers. One key advantage of Preferred Stock is its ability to convert into Common Stock, particularly during an IPO or other favorable exits. However, if venture capitalists stand to gain more by holding onto their Preferred Shares, they may choose to retain them rather than convert.

Why Venture Capitalists Prefer Senior Securities

Investors often opt for senior securities over common stock due to several key protections:

• Liquidation preference: Ensures that investors recover their funds before common stockholders in case of failure.

• Anti-dilution protections: Prevents the dilution of investor stakes if new shares are issued at a lower valuation.

• Voting rights and board seats: Investors secure influence over company decisions.

• Conversion to common stock in success cases: If the company performs well, preferred shares convert into common stock, aligning investor and founder interests.

Impact on Investment Banking

The terms attached to Preferred Stock can influence a startup’s exit strategy. For example, if venture capitalists secure highly favorable terms, company management may find an acquisition offer unattractive, preferring instead to pursue an IPO. Conversely, conflicts can arise when investors seek a quicker exit to recoup their investment, while founders prefer to build the company for long-term growth.

Types of Preferred Shares

1. Non-Convertible Preferred Shares – Function similarly to subordinated debt with fixed dividends but offer limited upside. These are rarely used in venture capital.

2. Convertible Preferred Shares – Allow investors to choose between receiving fixed dividends or converting into common equity to capitalize on growth.

3. Simple Convertible Preferred Shares – Investors either collect dividends and liquidation proceeds or convert to Common Stock for higher returns.

4. Participating Convertible Preferred Shares – The most commonly used type in venture capital. Investors first receive dividends and then share in any remaining profits alongside Common Shareholders, providing both downside protection and upside potential.

Multiple Classes of Preferred Shares

A venture-backed company often issues multiple rounds of Preferred Shares, each carrying different rights depending on risk and valuation. Generally, the latest round of Preferred Shares has seniority over earlier rounds in receiving dividends and exit proceeds. In some jurisdictions, Preferred Shares can carry both fixed dividends and pro-rata rights, eliminating the need for conversion.

Features of Preferred Shares

Liquidation Preference: The Safety Net

A defining feature of Preferred Stock is its liquidation preference (discussed in details below), which ensures that investors are paid out before Common Shareholders in the event of a company's liquidation. Typically, the liquidation preference is expressed as a multiple of the initial investment, such as a "1X preference." This mechanism provides a safety net for venture capitalists, guaranteeing them priority in capital recovery if the company does not perform as expected.

Voting Rights: Influence and Control

Preferred Shares grant investors voting rights, especially in critical decision-making areas such as acquisitions, financial planning, venture debt, and management appointments. These voting rights can be structured in two ways:

• As-Converted Basis: Shareholders vote as if all their Preferred Shares were converted to Common Stock, ensuring voting power aligns with economic interests.

• Share Class Vote: Investors holding Series A Preferred Stock, for example, must approve specific initiatives separately from Common Shareholders. This structure allows VCs to block decisions that might not align with their strategic interests while ensuring long-term stability for the company.

Anti-Dilution Protection: Safeguarding Investors' Interests

To protect against dilution caused by future funding rounds, Preferred Shares often include anti-dilution protection. This shields investors from valuation declines in a "down round." If the company’s valuation decreases, mechanisms adjust the conversion price of Preferred Shares to Common Shares. Additionally, pro-rata rights allow investors to participate in future funding rounds, ensuring they maintain their shareholding percentage.

The Waterfall Structure of Preferred Equity

Preferred equity sits at the top of the capital structure after debt, meaning it holds priority in repayment over Common Equity. Key aspects of this structure include:

• Sources of Preferred Equity – Common sources include family offices, hedge funds, and private equity firms.

• Control vs. Collateral – Unlike traditional debt, Preferred Equity investors seek control rights over assets, often defined in the operating or partnership agreement.

• Equity’s Upside Potential – Unlike debt, equity investments have uncapped upside potential.

• Defined Repayment Structure – Preferred equity repayment occurs after senior debt and mezzanine financing but before Common Shareholders.

• Preferred Return Rates – Investors often negotiate pay rates, such as a preferred return split (e.g., 70/30 after a 13% return).

• Control and Takeover Rights – If borrowers fail to meet obligations, Preferred Equity investors may gain control of the asset, potentially resulting in a hostile takeover.

• Exit Strategy – Upon a major event such as a sale or refinance, cash flows are allocated first to senior debt, then to mezzanine financing, and finally to Preferred Equity investors based on predetermined waterfall structures.

Series A Preferred Stock vs. Series B Preferred Stock

When considering investment in a company, investors and founders negotiate between different classes of preferred stock, each with distinct advantages and trade-offs. Two common types are Series A Preferred Stock and Series B Preferred Stock.

Series A Preferred Stock (More Company-Friendly)

Series A Preferred Stock is structured to be more favorable to the company, offering terms that balance investor returns while allowing the company flexibility in its operations. Key features include:

• Noncumulative dividends: If the company cannot pay dividends in a given year, the unpaid amounts do not accumulate and are not owed in the future.

• Liquidation preference at the original issue price: In the event of liquidation, Series A shareholders receive their investment back before common shareholders but do not necessarily have enhanced preferences over later investors.

• Mandatory redemption after five years: The company is obligated to repurchase shares after a certain period, ensuring liquidity for investors while allowing management to plan for capital commitments.

• Voting rights equal to Common Stock: Investors in Series A have the same voting rights as common stockholders, allowing them to participate in governance without additional control.

• No restrictive covenants: The absence of restrictions provides the company with greater operational flexibility.

Series B Preferred Stock (More Investor-Friendly)

Series B Preferred Stock, typically issued at a later stage and at a higher valuation, includes stronger investor protections and more favorable financial terms for shareholders. Features include:

• Stronger investor protections: Series B investors often negotiate for enhanced rights due to the higher risk associated with a later-stage investment at a premium valuation.

• Higher liquidation preference: Series B shares may have priority over Series A in liquidation, ensuring that later investors recover their investment before earlier investors and common shareholders.

• Stronger anti-dilution provisions: Investors often secure protection against future rounds of financing at lower valuations.

• Potentially cumulative dividends: Unlike Series A, dividends for Series B shares may accrue even if unpaid, increasing their attractiveness to investors.

Choosing Between Debt and Equity (Notes vs. Preferred Stock)

When raising capital, companies and investors must decide between issuing convertible notes (debt) or preferred stock (equity).

• Convertible notes: These are debt instruments that convert into equity upon specific trigger events (such as a future financing round), offering downside protection while allowing investors to participate in equity upside.

• Nonconvertible security with warrants: An alternative approach is to issue a nonconvertible note alongside a warrant to purchase common stock at the original price, separating the security into a fixed-income component and an equity participation right.

Advantages of Using Warrants

Warrants offer a strategic advantage by separating the equity investment from the fixed-income component:

• Investor recoups initial investment: The fixed-income security ensures that the investor recovers their initial investment, reducing downside risk.

• Equity upside remains: Investors still participate in potential stock price appreciation through the warrant mechanism.

Balance Sheet Considerations

Companies must evaluate the impact of financing choices on their financial statements:

• Preferred Stock strengthens equity: Enhances the company’s balance sheet and reassures creditors.

• Notes may introduce repayment obligations: Can create liabilities unless structured as subordinated debt.

Tax Considerations

Tax treatment influences the choice between debt and equity:

• Interest on debt is tax-deductible, making notes attractive.

• Dividends on preferred stock are not deductible but may qualify for corporate dividend deductions in some cases

Preferred Participation vs. Liquidation Preference

Preferred stockholders benefit from downside protection and, in some cases, upside participation:

• Preferred participation: Allows investors to convert into common stock and share in gains.

• Liquidation preference: Ensures investors receive a minimum payout before common stockholders receive proceeds.

Negotiation and Trade-Offs in Term Sheets

• Entrepreneurs negotiate for greater upside participation, often in exchange for taking on more downside risk.

• Investors prioritize security, ensuring they receive returns before founders and employees.

On Liquidation Preference

Liquidation preference is a critical concept in the realm of finance, particularly when it comes to determining how proceeds are distributed among shareholders in the event of a liquidation, sale, or other transformative company events. This mechanism primarily distinguishes between common and preferred shareholders, ensuring that those with preferred shares receive their due before any distributions are made to common shareholders.

There are three primary types of liquidation preferences to consider. The first is the Non-Participating Liquidation Preference, often referred to as Simple Liquidation Preference. In this scenario, preferred shareholders are guaranteed to receive a predetermined amount, typically their initial investment, prior to any distributions to common shareholders. This arrangement allows preferred shareholders to either convert their shares into common stock if that leads to a better return or to simply reclaim their initial investment.

However, a noteworthy concern arises in what is called the "dead zone." If the liquidation proceeds fall between the initial investment and a threshold that would have made conversion advantageous, preferred and common shareholders are left unsatisfied. For instance, if a company with equal shares finds an investor holding preferred shares worth €10 million and the funds from liquidation amount to €15 million, the investor recoups their original investment, but the common shareholders receive nothing. This creates a misalignment in interests since both groups are not benefiting optimally.

The second type is the Participating Liquidation Preference, often referred to as a "Double Dip." This structure allows preferred shareholders to first reclaim their investment and then participate in the subsequent proceeds as though they had converted their shares to common stock. This approach not only provides downside protection but also allows for upside participation. For example, if a company is sold for €25 million, an investor with a 1x participating liquidation preference would first recover their €10 million initial investment and then share in the remaining proceeds, receiving an additional €7.5 million given their ownership stake. This creates a total payout of €17.5 million, significantly more than what they would receive under a non-participating preference.

However, this model raises a separate concern: misalignment of interests, particularly affecting common shareholders. They begin to receive any proceeds only after the preferred shareholders have recouped their investments, which can perpetuate a cycle where common shareholders seldom catch up.

Lastly, we have the Capped Participating Liquidation Preference, which operates similarly to the participating preference but introduces a cap on the total payout to preferred shareholders, typically set at 2x or 3x their initial investment. This type ensures that while investors can still recover their initial investment and share in the remaining proceeds, they will not benefit beyond this defined cap. For instance, if an investor with a 1x participating liquidation preference has a 2x cap, they will receive their €10 million investment first, and then participate in the additional proceeds until they hit the €20 million cap. If the exit value exceeds €40 million, they will likely convert to common shares to partake in the remaining proceeds.However, even capped preferences present their own alignment issues, particularly when exit values lie in certain ranges, prompting a scenario where early-stage investors reach their cap but common shareholders only begin to benefit afterward.

In summary, understanding liquidation preferences is crucial for investors and companies alike. A Non-Participating Liquidation Preference guarantees a minimum return but limits potential upside unless shares are converted. On the other hand, the Participating Liquidation Preference provides robust protections and potential gains but can disproportionately favor preferred investors, often at the expense of common shareholders. Meanwhile, Capped Participating Preferences strike a middleground by limiting excessive investor gains while still providing some upside, alleviating some of the dilution concerns for common stakeholders. Throughout all these variations, the concept of misalignment—sometimes referred to as the "dead zone"—remains a persistent challenge that can sour relationships between different classes of shareholders.