As mentioned in the “Liquidation Preference 101” post, liquidation preferences can either be participating or nonparticipating. A nonparticipating liquidation preference only gives the preferred stock a liquidation preference over the common stock equal to the per share price the investor paid (or some multiple of that per share price). The effect of a nonparticipating liquidation preference is to require the preferred stockholder to convert their preferred stock into common stock to participate in any gain on their investment. Otherwise, they can choose to stay as preferred stockholders and get their liquidation preference. Therefore, if the preferred stockholder would receive a greater distribution by converting into common stock and receiving its pro rata share of the liquidation on equal ground with the other common stock, obviously, it would do so. With this structure, the investors are forced to convert to common stock if they want to participate in any gain.
For example, let’s assume that the founders of TechStartup, Inc. held 3,000,000 shares of common stock that they paid for at incorporation at $0.001 per share (or a total of $3,000), and Sandy Hill Ventures invests $2,000,000 to buy 2,000,000 shares of preferred stock (i.e. $1.00 per share). The percentage of ownership for the founders would be 60% and 40% for Sandy Hill Ventures. Sandy Hill Ventures has a nonparticipating liquidation preference at 1x of the investment amount (i.e. for the same amount that was invested).
Now, if TechStartup, Inc. was acquired for $10 million, the preferred stockholders would convert their preferred stock to common stock to participate in the gain. If the preferred stockholders did not convert they would only be entitled to their liquidation preference, or $2 million. By converting to common stock (assuming a 1 preferred stock to 1 common stock conversion ratio), the investors would receive their pro rata share of the $10 million along with all the other common stock. Therefore, Sandy Hill Ventures will now hold 40% of the common stock and entitle them to receive 40% of the $10 million, or $4 million. Clearly, it is an easy decision for Sandy Hill Ventures to convert and get a bigger bounty.
However, many venture capital investors now negotiate for a participating liquidation preference. Preferred stock with a participating liquidation preference will get their liquidation preference first and then have the opportunity to participate pro rata with the common stock. Assuming the $10 million acquisition of TechStartup, Inc., Sandy Hill Ventures would get a $2 million liquidation preference PLUS be allowed to participate in getting their pro rata share of the remaining $8 million. The residual $8 million (after the preferred stock gets paid its $2 million preference) will be divided pro rata between the common stock and the preferred stock as if the preferred stock had converted to common stock. Therefore, with a participating liquidation preference, Sandy Hill Ventures now gets a distribution of $2 million (i.e. the preference) PLUS $3.2 million in participation proceeds (i.e. 40% of the remaining $8 million) for a grand total of $5.2 million.