Uncapped participating preferred prevalent on the West Coast

Participating preferred are very often a sore topic of discussion with entrepreneurs who point out some perceived "immoral" characteristic as they provide the venture capitalist with a "double dip" i.e. two bytes at the cherry.  Many Euro entrepreneurs will argue that "in the Valley (a.k.a the Bay Area), you just don't see that kind of stuff".  Recent data from Fenwick and West suggest that may be wrong. 

A.  Quick layman's primer on participating prefs

For those not familiar with the concept, participating preferred are such that upon an exit event, the exit proceeds will first go to the venture capitalist, and once the VC has received its money back, than to all shareholders ratably... including the VC.  Hence the double dip monicker.

Personally, I like to negotiate my term-sheets based on logical rationale rather than brute economic force, since "one has less trouble accepting what one can understand".  Many entrepreneurs have seized upon this over the years in attempts to negotiate away the double dip.  I usually defend this rather simply on the basis that (a) I am trying to move their "wealth" point (the equity value number at which there is a serious cash out event for the entrepreneurs) further out to make sure they create enough value for the investors before exiting and (b) I am simply improving my return profile, since they do not want to agree to my ownership target :-).

A common compromise is to agree a cap on the double dip.  For example, the double dip would apply up to a 4X return threshold for the VC, followed by a straight line amortisation between the 4x and 5x return points to bring the founders back to pro-rata.  That way VCs protect the return in mid-range scenarios but the entrepreneurs don't feel screwed on the upside.  This is a factor of complexity as few people really grasp the calculations and you end up having to produce exhibits to show what the proceeds are at which price level.  All the while you could have been closing a new investment !!  and My personal view is that less is more when it comes to legal complexity.

After writing this I will also point you to the man for a more detailed discussion.

B.  Is Valley grass really greener ?

The Bay Area has always captured our imagination as the best place to start a new company, and rightly so.  But fascination with the region's ecosystem should not go too far.  Yes, driving down 280 is a unique experience, but local VCs drive a hard bargain too, as evidenced below.

Fenwick and West are a great legal outfit on the West Coast (I can recommend Bill Schreiber who did a superb job as counsel of Inxight Software) and publish an extremely useful "Trends of Venture Financings" in the SF Bay Area" which you should all subscribe to.  Jeff Clavier does a good overview as usual if you want the headlines.

I wanted to zero-in on the following stats:

• 71% of financings provided for participation in Liquidation
• Of those, 64% were not capped

In other words, 71% of deals involve a participation and 45% of all deals are uncapped participating.  What I am missing of course is the all-important definition of Liquidation, which tends to be company specific and can be key (clue: when is a sale not a liquidation ?).  However I think the numbers are fairly eloquent and should help all of us to take a more holistic view of what "market terms" really are when it comes to participating preferred.

Comments

[Jeff Clavier]

Liquidation can either be a change of control (sale) or wind up (close) of a business. The double dip (or the two bites of the apple, no cherry here :-) is sometimes an issue but many of the (early stage) deals I have done or seen recently were 1X non participating.

Sometimes VCs will put a preference wall in front of early stage founders to motivate them to look at the mid to long term, and avoid focusing on a short term M&A event. But all in all negotiating a cap of 1X, 2X or 3X is missing the point - which is that you want to build a company that will return 10X or more.

Also remember that F&W is a good but not exact proxy since these numbers only relate to cos that Fenwick has been involved in. So their numbers are skewed based on the types of businesses and stages that they serve (though they are a full service firm and as such has a broad spectrum of clients).

[Paul Jozefak]

I have to agree with Jeff that the "cap" of 4X or whatever you choose kind of defeats the purpose. Anything regarding "caps" somehow throws off expectations up front when negotiating the deal. If nothing else it skews each party's role!

I tend to always see it as a point on which to "compromise" because it also is one which really pisses off founders. You also said it yourself that it complicates things and compromising here leads to more clarity.

[Fred Destin]

I think the F&W data is based on 90 companies so I assumed it was based on a broader sample than just their work, otherwise it would indeed indicate only their skew as legal advisor ! If this is not the case then the title of my post is misleading. The point I was trying to make is that assumptions about West Coast terms are sometimes a bit too rosy. I will do further posts on what is wrong with Euro VC terms b/c I fully subscribe to your comments, i.e. that we are focusing on creating strong insurance policies in our set of terms rather than focus on growing large and succesful businesses. Personally I have always found part prefs slightly unpalatable.

[Jeff Clavier]

Well, the data F&W is reporting might include more than their own clients, though I had a feeling that those were deals where they were involved on either side (co or investor).
Tier 1 VCs have started to cap preferred participation a year ago (?) voluntarily because there is so much a VC can try to get. Owning too much of a company, and getting too much of the economic interest, means that the team is no longer incentivized. I have not found the same sense of balance from a lot of European investors, where I have seen too often a funding negotiation done on a win-lose basis - not win-win.

[Fred Destin]

You will get no argument from me on that one !!

[Jason Ball]

There was an article in the Venture Capital Journal earlier in the summer (available here) that argued for a return to "pre-bubble" plain vanilla convertible preferred stock with a 1x liquidation preference citing knock-on effects in follow-on funding rounds that tend to disadvantage early investors.

This is a philosophy I'd like to see gain some traction- we don't use preferred participating for a variety of reasons, but lean towards convertibles or straight equity. I think there's merit in the the VCJ article and believe preferred participating does move value from the entrepreneur (or early investor) to the new (later) investor.

Interestingly, Brad's article also argues that preferred participating can disadvantage early investors as well.

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