It is a well known fact that convertibles are the most commonly used securities in venture capital contracting especially in the US. The security of choice in most venture financed deals is convertible preferred stock. Kaplan and Strromberg (2003) in their empirical analysis of venture contracts find that nearly 80% of all venture financing use convertible preferred stock. Further, they also find that in nearly 50% of the cases the convertible preferred was participating. $Participating$ preferred means securities which participate in excess earnings with the common shareholder over and above their preferred dividend. One of the most important features of these securities is that they allocate different cash flow rights depending on whether exit occurs through a Trade Sale (TS) or an Initial Public Offering (IPO). We give below simple examples which illustrate this feature.
Assume that a venture capitalists( (VC) investment entitles him to $5 million in a given venture in the form of a Convertible Preferred (CP), which is convertible into 50 percent of the common equity. Further assume that the company is finally liquidated for $12 million. The VC then has two choices he can either convert his stake to common equity and be entitled to 50% of the proceeds i.e. $6 million or he need not convert and can be paid his preferred proceeds i.e. $5 million.
Participating Convertible Preferred (PCP) is similar to convertible preferred stock, with participation rights. Participating rights allow the holder to participate in excess earnings with the common shareholders in case of liquidation. Thus for simplicity in the above example assume that the PCP holder is entitled to participation rights of 50 percent. Again referring to the above example if the VC has invested $5 million and has a PCP stake then on conversion to common equity he gets $6 million (i.e. 50% of $12 million), but if he chooses not to convert he gets $5 million back plus shares in 50 percent of the remaining $7 million (i.e. $12 million minus $5 million). Accordingly the PCP holder can get $8.5 million (if he does not convert) and the common shareholders get the remaining $3.5 million. Thus it is obvious from both examples that the cash flow rights to the holder of the PCP varies depending on whether he converts his stake or not.
Most venture capital agreements provide for mergers or trade sale as a liquidation event, in which case the venture capitalist is entitled to participation/preferred rights. In contrast, most agreements provide for automatic conversion of the convertible stake into common equity in case of an IPO. There is therefore a clear dichotomy in the treatment of $participation/preferred rights$ of the VC based on the type of exit viz. IPOs and Trade Sales/Mergers. In giving up the participation and preferred rights during an IPO the VC in many cases is giving up a substantial portion of his cash flow rights. The question we address in this paper is why is the VC prepared to give up his rights in case of IPO and why not in case of a TS?
Downlaod
Participating Convertible Preferred Stock in Venture Capital Exits
