Although investing and building companies is a hugely rewarding experience for VCs, the ultimate reason VCs exist is to generate a return to their limited partners (the guys that fund Venture Capital firms).
One way VC’s try to protect their investments is by usually purchasing Preferred Shares (vs. Common Shares that founders own). Owners of preferred shares get paid back first in the case of an M&A exit (about 90% of all VC exits / vs. 10% in the form of IPO). However, at the time of an M&A exit, preferred shareholders have the option to convert their shares to common or keep their shares as preferred and get paid the liquidation preference value of those shares (usually 1x or a multiple of the per share invested amount). Note that in the case of an IPO, all the shares are converted into common shares.
To Convert or Not to Convert? That is the Question
The choice hinges on – you guessed it – whatever makes the VC get the highest returns. In our case, let’s look at two scenarios for an exit for Sweet Co:
1.) Good Scenario: After the A Round, Sweet Co. does really well, and gets sold for $50mm.
In the attached workbook, you’ll see that the share price at exit for each share of Sweet Co. in section I is $9.18, which ishigher than either the Seed Round or Series A round price (that’s good!). Because the value of the common shares is higher than the value of the preferred shares (in this case, the original purchase value), the VC will choose to convert their preferred shares to common stock. Notice that in this scenario – everyone wins. Founders get about $10.5mm, and investors get $35mm. Also notice the multiples calculation columns AN-AQ. This is one way how VC firms like Canaan looks at returns.
2.) Bad Scenario: After the A Round, Sweet Co. doesn’t do well and is offered a low acquisition value of $5mm.
In the attached workbook, you’ll see that the share price at exit for each share of Sweet Co. for section II is only $0.92, which is lower than either the Seed round or Series A round price (that’s bad!). Because the value of the common shares is lower than the value of the preferred shares (in this case, the original purchase value), the VC will choose to trade in the preferred shares for its cash value. What’s more, the investors take out their money first.
Since the investors have invested a total of $4.5mm, there is only $500k left for common shareholders. However, because the preferred shares no longer exist (since those shares were traded in for cash), the total share balance drops to 1.5mm shares vs. 5.5mm shares. In this case, the founders and option holders own 100% of the remaining shares so they only get $500k. Notice that the venture capital firm got their money back (a 1.0x).
Next week – I’ll talk about more complex preference and liquation structures!