Not All Prices Are Equal – The Great Deal May Not Be So Great

You’re raising money and you manage to secure two term sheets. Yay! When you have a term sheet in-hand it’s a great feeling, even though there is a long way to go between the terms sheet and cash in your company’s bank account.

Which term sheet do you proceed with? The one with the higher valuation, right? (Duh!) Well, maybe. Not all valuations are created equal. Years ago, a friend of mine who is an angel investor once told me, “You can name any price you want, if I get to name the terms.” It took me a while to understand that, until I started performing a lot of valuations for emerging software companies. But when that happened, the wisdom of that axiom became clear to me.

Over the next several issues, I will share thoughts with you to help you understand the financial ramifications of terms that you are most likely to encounter. The most frequent term we encounter is the issuance of preferred shares in exchange for the investment sought.

Preferred Shares

Preferred shares are hybrid securities – part debt and part equity. The debt component manifests itself in the form of having a senior claim to the common shares in the event of a liquidation, called a liquidation preference. However, the preferred shares’ claim will be junior to those of any creditors, and preferred shares don’t typically have a claim on specific collateral assets.

Further, most of the time, preferred shares carry a guaranteed dividend, meaning that the preferred shareholders accrue dividends (usually, cumulatively) that must be paid either upon a liquidity event or prior to issuing dividends to common shareholders. We typically see dividends on preferred shares in the range of 5%-8% of the par value of the preferred shares themselves, and this accrued dividend amount is added to the liquidation preference of the preferred stock stake.

Liquidation Preference

This liquidation preference is usually equal to the amount of capital originally invested plus accrued dividends, but it does not have to be so. When this is the case, it is often referred to as a one-x (1x) liquidation preference, meaning that the amount of the liquidation preference is equal to the amount invested plus accrued dividends. However, we have encountered liquidation preferences that were less than 1x (which favors the company raising the capital) or more than 1x, (which favors the investor).

The liquidation preference is designed to provide downside protection to investors, but on its own it limits the upside to the amount of the liquidation preference – holders of plain vanilla preferred shares would only receive the amount of their liquidation preference even if the company products a spectacular exit. For this reason, 90%+ of the time, preferred shares are convertible into common shares – meaning that the owner can convert their preferred shares into common shares at their option. The convertibility feature of preferred shares is what most strongly lends to the characterization of preferred equity securities are hybrid in nature.

Convertibility of Preferred shares

The presence of liquidation preferences and convertibility of preferred shares transfers value to the preferred shareholders from the common shareholders. Depending on the company’s facts and circumstances at the time of the investment, as well as contemporaneous market conditions, the transfer of value can be quite significant, and the headline pre-money valuation of the company may be significantly less than the fully diluted implied value. The value compression sharpens when more, senior series of preferred shares are sold.

How much value is transferred requires fairly involved mathematical analysis, and we can help. Contact us if you have a question about a term sheet that contains a preferred stock term.

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