In the previous example, we reviewed the concept of non-participating preferred shares. As a reminder, non-participating preferred shares give the VC the option to trade in those shares for their liquidation preference value.
However, there is a structure that is usually more beneficial for investors called Participating Preferred, which gives the investor the liquidation preference value for his preferred shares, but then lets him participate as if he were a common shareholder for the remaining sum of money.
Modeling returns for participating preferred shares holders is actually easier than for non-participating preferred share. In the case of participating preferred there is no complex math when structuring returns because the VC will ALWAYS exercise their share’s liquidation preference value and then participate as if they were common shareholders.
Let’s look at the previous example, but this time using a participating preferred structure.
1.) Good Scenario: After the A Round, Sweet Co. does really well, and gets sold for $50mm.
In the previous example of non-participating preferred, the VC chose to convert to common shares because that would lead to better returns than exercising his liquidation preference. However in the participating preferred scenario, the VC will always exercise his liquidation preference and then participate as if he were a common share holder. In the attached workbook, you’ll see that the VC investor gets a return of 8.2x on their money vs. the 8.0x on their money under the non-participating preferred scenario.
Notice that in this scenario – everyone still wins – but the investors win a little bit more.
2.) Bad Scenario: After the A Round, Sweet Co. doesn’t do well and is offered a low acquisition value of $5mm.