June 21, 2022Blog

Liquidation Preferences: The Reality Behind the Zone of Indifference

As the venture capital sector slows down, valuations and deal sizes are pulling back from the recent record highs.  Seemingly, “investor friendly” deal terms are once again making an appearance in term sheets. 

One investor-friendly term that is making a comeback in today’s market is “participating preferred” stock.  When it comes to participating preferred, in the event of an exit transaction involving a sale of the company, investors get a preference payment, and then also share, with the common shareholders, in the remaining proceeds on an as-converted-to-common basis (i.e. a concept that is based on the assumption that all shared of preferred stock have converted into shares of common stock).  Typically, an investor’s preference is equal to the amount invested plus any declared or accumulated but not yet paid dividends.  (In most cases there are no such dividends, and for purposes of this blog we’ll make that assumption.)

Fully Participating Preferred.

Consider, by way of example, a case where Acme Ventures invests $1 million in Newco for 40% ownership in the form of participating preferred stock.  Table 1 models the distribution of exit proceeds over a range of exits from $500,000 to $100,000,000.

Table 1: Full Participation

A couple of things to note in this distribution model.  First, the investor gets all the proceeds until she has received her entire $1,000,000 preference.  That’s the primary goal of participation.  But note something else: The maximum “extra” payout from participation is $600,000.  No matter how big the exit proceeds are, the investor’s participation bonus will never be more than $600,000. 

And that reveals an important fundamental of participating preferred: it’s significance in the distribution waterfall is mostly felt in “sideways” deals.  That is, deals that earn a positive but modest overall return.  As the payout grows, the “bonus” for participation, and the “penalty” it imposes on the common, become increasingly less significant in the overall scheme of things.  And that’s why investors think of participation primarily as “downside” protection even as founders think of it as “double-dipping.”

Capped Participation: A Compromised Compromise

As it turns out, there are stops along the road from entrepreneur-friendly nonparticipating preferred to investor-friendly participating preferred.  Those stops come in the form of caps on investor participation.  So, for example, if an investor has a 3x participation cap on a sale of the company, the investor will choose between getting all the proceeds up to 3x the amount invested or foregoing the preference and sharing the aggregate proceeds with the common shareholders on an as-converted basis.

Consider again the scenario where Acme Ventures invests $1 million in Newco and owns 40% of Newco on an as-converted basis, and the other 60% is owned by common shareholders.  But this time we’ll put a 3x cap on participation.  Table 2 below shows the exit proceeds distribution over a range of exit proceeds values.

Table 2: 3X Cap on Participation

Of note in Table 2 is that every dollar of exit value above $6 million up to $7.5 million is paid to the common shareholders.  Good for them, right?  Well, yes and no.  Because if all those dollars accrue to the common holders, the preferred holders have no incentive to negotiate hard with the buyers above $6 million unless they think they can get to an exit value substantially above $7.5 million.  Thus, the so-called “Zone of Indifference,” which in this case is between $6.0 million and $7.5 million.

How important is the Zone of Indifference?  Well, that depends on several factors.  First, it really doesn’t make any difference at all if the likely exit proceeds don’t fall in the general range of the particular Zone of Indifference.   If they do, it depends on how much influence the preferred holders have on the exit price negotiations.  And that can vary from no influence at all to complete control, depending on the terms of the preferred investment agreements (e.g., voting rights, drag-along provisions, etc.).

Secondly, Table 2 illustrates an additional point.  Capped participation, like full participation, mainly impacts sideways exits.  Indeed, once the exit proceeds get well beyond the cap, the distribution in the capped case will be the same as if there was no participation at all.

Lastly, I have two final notes on capped participation.  First, it is imperative to recognize that the smaller the percentage ownership of the preferred stock, the bigger the Zone of Indifference.  For example, let’s keep  the facts the same as in Table 2 except assume that the preferred stake is only 10% instead of 40%... In this new instance, the Zone of Indifference grows from $1.5 million to $9 million ($21 million to $30 million).  Second, as best illustrated in Table 3 below, as the cap grows, the zone of indifference is pushed out to larger exit values.   So, keeping the preferred at 40% but increasing the cap to 5x pushes the still $1.5 million Zone of Indifference out to exit values between $11 million and $12.5 million.

Table 3: Preferred at 40% with 5x Cap

Final Thoughts

As the market shifts from greed-driven to fear-driven, valuations will fall, and investor-friendly terms will be dusted off and reinserted into a lot of deals.  One of the more significant of those terms is participating preferred, in both its full and capped forms.  Entrepreneurs should understand the implications of participation, including the nuances of capped participation and the interplay of those nuances with other investment terms.

Next time, a look at a possible alternative to capped participation – partial participation. 

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