In our Fundraising 101 intro post, we discussed the high-level differences between debt and equity with respect to raising capital. Today we’re going to take a deeper dive into the details of preferred shares.
Common vs. Preferred
Generally, with each round of funding, equity is given up in exchange for capital. Not all equity is equal, though: there are clear distinctions between classes with respect to rights within the company, priorities in liquidation and repayment of debt, and guarantees.
When a company is first founded, the owners will hold common stock and/or stock options. Common stock affords voting rights and privileges within a company, however it is the last to be repaid if the company experiences a liquidation event, such as bankruptcy. The company will first pay outstanding loans and preferred stockholders in full, before paying the common stockholders. Consequently, common stock is riskier than preferred stock (or debt).
Preferred stock is a type of equity in which there are special priorities and guarantees. Generally preferred stock comes with fewer voting rights and influence over the decision making process when compared to common stock. There is often more protection against downside risk for preferred stock, however; they have higher priority over common stock for dividends and liquidation
With every round of funding, more equity is granted. Even if all these are the same types of stock (e.g., preferred), there are still distinctions in priority in cases of liquidation. Generally, later rounds raised have priority over earlier rounds, unless otherwise specified. In the case in which a company’s value has decreased and it’s unlikely that all shareholders will be able to receive a return of their contributed capital, holders with seniority and liquidation preferences have a greater likelihood of recovering their invested capital.
Preferred stock will often have conversion rights negotiated as part of the purchase agreement to allow shareholders to convert some or all of their preferred stock into common shares. A conversion ratio dictates the price and rate at which preferred stocks can be exchanged into common stock. Some circumstances, such as an IPO, might lead to the company actively seeking for the conversion of preferred stock into common stock.
Preferred stock may have a liquidation preference. Liquidation preference gives preferred stockholders the right to receive a multiple of their invested capital in the case of a liquidity event or sale of the company. A 2x multiple, for example, means that a $5 million investment must return $10 million to the shareholders holding this class of shares before less-senior shareholders receive any cash. Among preferred stock holders, the terms of their preferred stock might not always be the same; liquidation preferences in the preferred stock may differ from round to round based on the specifics of the purchase agreement for that investment round.
Preferred stock is often classified as “participating” or “non-participating.” In the case of a liquidity event or sale of the company, participating preferred stock receives both their liquidation preference and their respective share of the remaining payout based on their percentage of ownership. Non-participating preferred stock, on the other hand, requires the shareholder to select a payout based on either their liquidation preference or their ownership percentage. Given the “double dip” nature of participating preferred stock, it is less common to see – in the first quarter of 2022, 98% of disclosable deals involved non-participating preferred stock.
Participation caps serve as a mechanism to limit a preferred shareholder’s participation rights. Caps are usually stated as a multiple of the shareholder’s initial investment (similar to – and often in conjunction with – the liquidation preference), such as 2x. In the case of a 2x participation cap, the participating preferred shareholder would receive the amount of their liquidation preference (e.g., 1.5x) and would receive their pro rata share of the remaining distribution up to 2x their original investment. If the company’s valuation had increased significantly since the shareholder’s investment, the cap would greatly limit how much of the funds would be allocated to that preferred stockholder.
With each round of fundraising, stock from previous rounds of funding are diluted. This is less problematic when the company’s value increases – each shareholder has a smaller piece of the pie, but the size of the pie has increased. When the company’s valuation does not increase by more than the amount of the dilution, however, shareholders experience an overall decrease in the value of their shares. Consequently, many investors negotiate for anti-dilution rights as these protect them against losses due to down-rounds by lowering the conversion price of preferred shares into common shares. For the company, however, anti-dilution rights of current equity holders can make negotiation of future investments more complex, as later investors may seek to alter these protections
Anti-dilution rights are calculated using one of two methods: full-ratchet or weighted-average. The method used to calculate the adjustment is negotiated as part of the equity raise; weighted-average anti-dilution is significantly more common – in Q1 2022 more than 96% of deals with anti-dilution provisions were based on the weighted-average method.
Full Ratchet Anti-Dilution
This method uses the current common share price as the new conversion price to determine how many shares of common stock the preferred stock can be converted.
This method calculates the new conversion price and accounts for the amount that is raised at the lower valuation (“down round”). Unlike the full ratchet method, weighted-average anti-dilution accounts for the size of the investment and the difference between the prior share price and the current share price.
It’s important for founders to consider the advantages and disadvantages of what conditions are agreed to in each round of fundraising; these can influence the payout of investors and even the likelihood and ease with which future rounds can be raised.