It’s the first day of the New Year and now that 2016 is over it’s probably appropriate to look back and reflect on all the positive things that happened last year. Professionally, I was able to work with a stellar team to create a new investment fund for our company. I got a title change from Manager to Director. Our firm had two portfolio companies get acquired, and I had the opportunity to talk to nearly 240 entrepreneurs from all around the country.
One of my goals in 2017 is to get more heavily involved in structuring and negotiating deals with entrepreneurs. Most people in this space understand the basic mechanics of equity and debt deals, but there can be several nuances to them. In my experience, many of the terms outlined in the term sheets that I’ve seen rarely get put to practice, but when they do, it can become a really big deal really fast. For example, redeemable preferred stock is an often misunderstood term that many investors don’t understand and often confuse with participating preferred stock. There are a several types of preferred stock, but I’m going to discuss the differences between redeemable preferred and participating preferred stock.
Participating preferred stockholders are entitled to a predetermined interest payment and have the right to convert to common shares. Converting to common shares is advantageous in that it allows one to participate on an equity basis if the company is ever sold or goes public. Common shareholders are not guaranteed an interest payment like preferred stockholders, but they are guaranteed the right to their piece of the pie once the preferred stock holders and note holders receive their share. In most cases, investors negotiate for participating preferred shares because it protects the investor in case he or she has paid too much for the shares and it motivates the entrepreneur to not sell the company too early at a low valuation. It is possible for entrepreneurs to negotiate a capped participating preferred, which essentially puts a limit to how much investors are paid back in the event of a sale. I certainly encourage entrepreneurs and investors to learn more about this feature.
Redeemable preferred stock (RPS) is different from participating preferred stock in that it is more like a loan to a company versus a pure equity investment. RPS is simple – I invest $2M for 2 years at a 10% interest rate and when the company is sold, say for $5M, I am guaranteed $2.4M, and the remaining $3.6M is split with the common stockholders. Unlike participating preferred stock, RPS holders cannot participate in the remaining $2.6M because their shares do not convert into common. There aren’t very many circumstances where redeemable preferred stock is preferred over participating preferred, but they are used. In fact, redeemable preferred stock is often paired with common stock, as this combination guarantees that the investor is paid back what they are owed and it gives them the opportunity to participate in the future potential upside of the company, which is what most investors ultimately want anyway.
In summary, it is important for both entrepreneurs and investors to take the time to understand the differences between redeemable preferred stock and participating preferred stock. When either party is confused it can cause major problems down the line. So be sure you have an experienced attorney, or someone familiar with these terms, to ensure that everyone gets what they want and the deal doesn’t go sour.