Feld Thoughts: To Participate or Not (Participating Preferences) Brad Feld is one of the six or seven venture capitalists that I know of who also write very interesting weblogs. If you are at all interested in venture capital and how

I�d push back that it�s �not a standard term� as I don�t really know if anything (outside of reg rights and some sort of preferred of return) is standard.

Furthermore, I think the flat spot in the capped participation usually helps out the common, so I don�t get too caught up in it. What is more interesting is with a capped PP, every new preferred investor (Assume same capped amount and up round) takes money away from older preferred (even assuming pro rata involvement), to the point you�d be better off having no capped participation.

That is why you see sometimes the capped number going down as valuations go up.

Brad Feld’s blog (Feld Thoughts) is a great source to learn quite a bit about the VC world.  In a recent pos…

However, I’m not as intellectually troubled that either “capping” or eliminating the PP feature misaligns management and the VC.

It’s important to note that “flat spots” are associated with the return curve of at least one of the securities in any company with a liquidation preference. If a flat spot was the problem, in and of itself, the only way to solve for this is to remove the liquidation preference entirely. For example, a “flat spot” is created on the return “curve” for non-participating preferred too. However, since the flat spot in NPP is created with the first penny distributed beyond the liquidation preference, many VCs object that the entreprenuer actually makes money (assuming a nominal purchase price on founders’ shares) by a sale that marginally exceeds the liquidation preference, while the VC only receives a return of capital.

The primary purpose of creating a PP with a “cap”, as perverted as that my sound, is to better align the interest of the common and the preferred in a potential sale that exceeds the liquidation preference with an average return, while maintaining for the entreprenuer the stretch goal to earn their way back to the the position of “equality” that would be acheived if the company were to go public.

If the VC accepts this as valid compromise objective, this additional incentive requires one to move the flat spot on the return curve associated with a non-participating preferred further to the right, immediately following the “cap” level in a capped liquidation preference. It essentially creates an economic “accelerator” for the entreprenuer for a job well done. I don’t see anything “weird” about that. To say anything contrary, would be darn right un-American. For those who don’t recognize it, the last two sentences are merely humor, not true emotion.

I pulled this quote from Venture Blog not so much about its topic, but about how blogging has opened up …

I pulled this quote from Venture Blog not so much about its topic, but about how blogging has opened up …

If you think that a ‘double dip’ refers to dining and you are raising funds you better read Feld Thoughts…

Be sure to realize that I think liquidation preferences are a completely appropriate mechanism for early stage investors.

The point I am trying to make (perhaps sarcastically) is that the downside protection that VCs want is ultimately just an economic provision, just as the participate is just an economic provision. You could get terms that economically balance the lack of a liquidation preference, but you wouldn’t, because that’s not the way you like to do things. Similarly, your “entrepreneur friend” could get terms that balance a participate, but he won’t, because he doesn’t like to do it that way. In both cases, it’s more about what “feels right” than the actual economic analysis.

In the end, it’s really all just a negotiation, and the posturing about what’s “fair” and “appropriate,” and “reasonable” is all just posturing. The goal (and responsibility) of the VC is to balance getting as high a fraction of the return as possible back to the fund, while making sure the entrepreneurs are motivated enough to make the company successful (i.e., the size of the pie and the slice of the pie). This is a tricky business and not one that I envy.

Your example of the day-after distribution is easily fixed by covenants and governance provisions. The lack of a liquidation preference doesn’t mean there are no other strings attached.

The real message of a participate, and although you make the point I think it is easily lost on first-time entrepreneurs, is that the reason VCs invest is to aim for a very high return. This can create many disconnects between the investor and entrepreneur after the investment:

ENTREPRENEUR: There are a bunch of customers over here who need our technology.

VC: That’s too small a market. Ignore it. Go for that longshot over there.

This seems irrational to the entrepreneurs, but it’s not irrational — it’s a high-risk, high-return posture. Instead of saying to the entrepreneur “the participate is a standard term and we believe it’s justified”, say “that’s in there so that every day you wake up and realize that you’re not getting much money out of this unless it’s a huge success.”

I know that YOU have this conversation with people, but I don’t think most VCs do.

But I’ll look forward to your post.

You didn’t comment on whether a participate with a “phased-out” LP would work or has been tried.

I agree with your a, b, c that are the goals of a good capital structure. I think what your “entrepeneur friend” was trying to tell you is that participates do not satisfy (b) and (c) for the entrepreneur (or, at least for him) — and I would add that for line employees (but probably not management) they do not satisfy (a) either.

Feld Comment: While I wouldn’t ever do an early stage deal without a liquidation preference, I’d still rather have 25% with a liquidation preference than 33% without a liquidation preference (I’m assuming you mean a simple liquidation preference rather than a participating preference.) Here’s a challenging situation – assume 33% without a preference (the entrepreneurs own 67%). The investment is $5m in a company that has never made a profit. On the day after the investment, the entrepreneurs decide to liquidate the company. Since they own 67% of the company, theoretically they can do this and take 67% of the newly invested cash.

Fundamentally a venture capital investment – especially an early stage one – has strings attached – one of them is that the investor has some downside protection. A liquidation preference is part of this downside protection. The participate is a more economically aggressive version that combines the downside with improved economics on the upside. If you don’t like the notion of the strings, then venture capital is probably not for you.

Regarding a phased out liquidation preference – this is certainly a valid approach to get rid of the flat spot. I’ve never used it nor have I encountered it, but it’s an interesting, albeit potentially mathematically complicated, approach to bridge the gap between a capped participate and a full participate.

I find it interesting that you use the term “perversion” to describe capped participates and multiple participates. That’s a highly emotionally laden term… yet these are just further twists on what is, after all, just economics.

Further, in my experience, VCs get very EMOTIONAL about the idea that their cash should have a liquidation preference. Why is that? Investors in an IPO don’t get a liquidation preference, and their money is just as green.

One other technical point: a capped participate can also be viewed as a “multiplier preference” where the common shares in the return above a certain point. As companies started to fall apart during the later stages of the Internet bubble, some investors turned the screws and insisted on a 2x or 3x liquidation preference. Again… just another economic term… liquidation preference doesn’t need to be tied to the cash. A capped participate is just a variant on this that allows the common to get some return sooner.

I still like my idea of a phased-out liquidation preference with the participate. Has this ever been tried to your knowledge?

Feld Comment: I didn’t intend “perversion” to be an emotional term. Unfortunately, I can’t support that with an dictionary.com definition since – other than the sexual references – it’s apparently a “a change to something worse; a turning or applying to a wrong end or use” (I always thought of “pervert” as “weird” – guess I’ve got to modify my internal dictionary – but than again, I have trouble with then and than). So – no emotion intended (even though it appears it slipped out – I’m sure I’ll get called a pervert the next time I propose a partipating preference cap.)

The base liquidation preference (not the participate) is more than an emotional point for VCs – eliminating it is a non-starter in 99.9% of the cases. It’s a longer discussion as to why this is the case – I’ll save it for a later post.

I thought I talked about multiplier preferences in a way that was generalized enough. It can apply whether or not there’s a preferred preference in place. It’s typically used when one or more of the existing investors don’t participate in a financing and the investors (or the company) is unwilling to do a recapitalization. Multiplier preferences are intended to “punish” investors who chose not to participate in future rounds – if all investors participate then they are usually unnecessary. However, there are lots of unintended consequences associated with them, including the obvious situation where there is a dramatically increased preference over the common shares. Again, a complicated situation that I’ll try to explain in a future post.

One of the big challenges with all of this stuff is that the capital structure of a company can quickly become very complex which makes it very difficult to (a) understand what is going on, (b) create a situation where all parties are appropriately motivated on a going forward basis, and (c) set up an end-game situation where everyone feels like they shared appropriately in the risk / reward situation. Hopefully some of these posts and ensuing discussion will help with that.

Besides, the flat spot is easily remedied. The liquidation preference could phase out as the participate scaled up. Then there is no flat spot, the investor gets above-share returns for lower proceeds. Hmmm, you could even have the common’s share start at dollar one, in a very small share, and increase monotonically over the range of proceeds — this would solve any number of “alignment” problems.

The PP becomes an emotional issue when VC’s use it not so much for downside protection but as a way to juice returns even in high valuation merger exits. Instead of dealing with the up front valuation expectations by establishing the appropriate pre-money valuation many investors try to juice the returns in this backdoor way. The problem is this can create really perverse incentives once mgmt and employess catch on and are presented with the option of an exit via an ipo (no PP) or merger (with PP). All things being equal and depending on the size of total liquidation preference they will be naturally incented to drive to an IPO exit which may not be the right thing for the company. That is why PP’s are almost always recut/reneogiated on a merger deal in order to get the proper alignment between investors and management. In most situations this negotiation can happen in a constructive way but sometimes based on how much the PP was relavant in the IRR calculation of the investor it can be pretty messy.

IMHO, PPs should be used for downside protection and therefore a cap is appropriate. If investors want it for return enhancement they should deal with the economics throught the front door on the pre-money valuation so there are no surprises when you are looking to a non ipo exit.