Venture capitalists over time have turned preferred stock into an art form. Not only do VCs use preferences for down-side protection, they also demand features that ensure that they get a sizeable return on their investment before the founders see one red cent. One of these features is the liquidation preference, for which VCs may ask (and get) a multiple of their investment no matter how short the time period is until they push to sell your company. The other feature is participation. In participating preferred stock, the VC receives a liquidation preference and in addition participates as if he had converted to common stock. Of course, participating preferred never converts to common, because the investor always gets more by not converting. That makes participating preferred a toxic instrument that, like the dead albatross in Coleridge’s “Rhyme of the Ancient Mariner”, hangs around the founder’s neck forever.
I recall the first time a client successfully sold a venture-financed company in a transaction in which I served as counsel. My client made a small fortune on the sale of his company, but was somewhat irked that the VC made a large one. I had to explain to the founder that he not only had to pay the VC a fair share of his company, but he also had to help the VC recoup losses from all the failed investments the VC had made.
So venture capital is an expensive (but necessary) part of the life cycle of many start-up companies. And that means that angel investors, knowing that VCs may be investing in subsequent rounds, need to help founders with a smooth transition. If a start-up anticipates multiple angel rounds, the first of these may be in the form of a convertible note for which the investor receives the same security as in the subsequent round, but at a discount. However, if the subsequent round is a venture capital round, the VC will object to the angels piggy-backing on the VC’s 2X liquidation preference and full participation with the common (not to mention that 30% discount.) In considering preferred stock, the company and the angels therefore have an incentive to ensure that it does not become toxic.
It is not hard to compare the impact of accrued dividends to liquidation preferences. For example, a 2X liquidation preference is equivalent to a 25% non-compounded dividend if there is an exit in four years. A mandatory or so-called “cumulative” dividend can therefore be effectively deployed in angel deals. The dividend is rarely paid and instead accrues to the liquidation preference. The stock pays no liquidation preference upon conversion. Therefore, the dividend only comes into play if the liquidation preference exceeds payment that the common stock would receive upon a liquidity event. In that case, the angel investor would not convert and instead receive the preference.
Were a company to offer a dividend of 10%, for example, angel investors would have an incentive to sign on early and not wait to come in at the end of the round. A dividend at a fair rate whose true cost varies to reflect the time value of money makes sense for all participants. In an angel round, where investors may enter over an extended period, a new series of preferred stock can be issued on each closing date. If the dividend does not compound, the company can close on the investment any day that an angel wants to write a check.
I invite your comments to this blog post and look forward to posting another missive in the near future.
John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington. This posting does not constitute legal advice.