Most successful startup companies will eventually mature to the point where they need to raise a round of institutional venture capital. Such companies face an important decision: whether to seek VC from an east coast or west coast firm. Although the answer will often depend upon the startup’s geographic location and industry, emerging growth companies need to understand that there are many key differences between west coast and east coast investors.
One important distinction lies in the concept of participating preferred stock, a deal term more commonly found on the east coast. Participating preferred refers to preferred stock with a special liquidation preference. In a deal with participating preferred stock, investors will receive full return of their investment before any other money is paid out, and then also ‘participate’ in the distribution of the remaining proceeds, up to an agreed upon multiple (often 2x or 3x) of the investment.
As an example, consider a VC with a 3x participating preferred invests $10 million in your company for a 50% stake. If you later sell the Company for $50 million, a common, but misplaced, expectation would be that the VC would receive $25 million, equal to their 50% equity stake in the company. In reality, the VC will get their $10 million investment back, and will then receive an additional $20 million (50% of the remaining $40 million). This gives the VC a total of $30 million, or 60% of the sale proceeds.
As you can see from this simplified example, participating preferred stock effectively reduces the amount of money left for the founders and executive team. As such, emerging companies should recognize that participating preferred is an important deal term that requires careful negotiation. Failure to do so will often result in investors receiving a far greater share of sale proceeds than the founders intended.