It is not uncommon for private equity-funded or early-stage companies to issue preferred stock when raising capital. The terms of preferred stock can vary widely from company to company, but the presence of both preferred and common shares in a company creates a complex capital structure that adds another step to the valuation process. When a complex capital structure is present, once the value of the company’s equity is determined, that value must be allocated to the preferred and common shareholders, a process commonly described as a “waterfall.” What many investors who hold common shares do not realize is that the terms of the preferred shares often divert a majority of the company’s value to the preferred shareholders, leaving very little for those who hold common shares (even if the company has experienced significant growth).
The terms of the preferred shares can oftentimes influence the value of the common shares just as much, if not more, than the underlying value of the company. The following are common preferred stock provisions that can significantly influence how much of a company’s value is left to allocate to the common shareholders:
Liquidation Preference – It is customary for preferred shareholders to have a liquidation preference over the common shareholders (and possibly the holders of previously issued preferred shares). This preference allows for the preferred shareholders to receive the amount of their investment (or some other stipulated value, sometimes including a premium) back in the event of a sale before any remaining funds are divided among the other shareholders of the company. Liquidation preferences “block off” a certain amount of value for the preferred shareholders before the common shareholders can expect to receive any proceeds.
Preferred Dividends – Preferred shares also commonly have an annual preferred dividend (stated as a dollar amount per share or as a percentage of the per share face value). These annual preferred dividends must be paid before the common shareholders can receive any dividends. Preferred dividends are often cumulative in nature, meaning that any preferred dividends not paid in one year carry over into future years. It is also a common requirement that the preferred dividends be paid in full with proceeds from a sale of the company (in addition to the liquidation preference) before any funds can be distributed to the common shareholders.
- Participation Rights – This can be a very impactful provision that results in severe dilution to the common shareholders depending upon the company’s capital structure. “Non-participating” preferred stock does not receive any proceeds above and beyond the liquidation preference and cumulative preferred dividends in the event of a sale. It is not uncommon, however, to also see “non-participating” preferred shares with a conversion feature that allows those shares to be converted into common shares if the sales price is high enough to make this a more attractive option. “Participating” preferred shares, on the other hand, share in the proceeds remaining after the satisfaction of the liquidation preference and cumulative preferred dividends on a pro-rata basis with the common shareholders. Therefore, depending upon the number of preferred and common shares outstanding, the “participating” preferred shareholders can wind up leaving very little value for the common shareholders, even if the company’s value has increased significantly.
The preceding factors, as well as other provisions of preferred shares (which vary on a company by company basis), can severely impact the value of common shares held in an entity. It is important for common shareholders to keep this in mind when raising equity through the issuance of preferred shares. This also should be considered when common stock options are being issued since what may look like a meaningful grant to an employee could really have little value due to the claims that the preferred shareholders have on the value of the company.
For more information on issuance of stock options, contact Sean Saari by leaving a message below, or by calling 440-449-6800.