Investment terms
There are several friends asking me about investment terms, so instead of answering each one, here is the page on the key ones
Liquidation Preference
“Liquidation preference” refers to the dollar amount that preferred stock holder will receive prior to common stock shareholders in the event that the company is sold or the company is otherwise liquidated and its assets distributed to stockholders. For example, if holders of preferred stock have a liquidation preference equal to $10 million and the company is sold, they will receive the first $10 million before common stockholders receive any amounts. The liquidation preference amount can be paid in cash or stock from the acquisition.
- “Senior” Liquidation Preference
A series of preferred stock has a “senior” liquidation preference when it is entitled to receive its liquidation preference before another series of preferred stock. In general, all series of preferred stock will be “senior” to the common stock. For example, if the Series B has a $25 million senior liquidation preference and the Series A has a $25 million liquidation preference and the company is sold for $30 million, the Series B will receive$25 million and the Series A will receive $5 million.
- Multiple Liquidation Preference
In certain financial condition, new investors may require their liquidation preference amount be more than the amount they originally invested. This practice is often referred to as a “multiple” liquidation preference. Multiples could range from 1x to 5x of the purchase price based on market condition and investment risk. I saw 10x once in my investment lifetime also… For example, if the Series B investment is for $10 million, but has a multiple liquidation preference equal to two times (2x) of the purchase price, then the Series B investors will receive the first $20 million on any sale of the company before the Series A or common stockholders receive any payout.
- Participation
Preferred stocks are said to “participate” or to have “participation” rights when, after the holders of preferred stock receive their full liquidation preference amount, the investors are then entitled to share with common stock holders for the remaining amount being paid for the company.
- Capped Participation
Participation rights are considered to be “capped” when the participation rights of the preferred stock are limited so that the preferred stock stops participating in the proceeds of a sale (or other distribution) after it has received back a pre-determined dollar amount.
Antidilution Provision
Antidilution provision retroactively reduces the per share purchase price of preferred stock if the company sells stock in the future at a lower prices. This is one of the main tool investors use to eliminate downside risk. It is accomplished by increasing the conversion rate of the preferred at which a share of preferred stock converts. There are two main types of price protection: weighted average antidilution protection and ratchet antidilution protection.
- Weighted Average
Weighted average antidilution increase the conversion rate of the preferred stock based on a formula that is intended to take into account the overall economic effect of the sale of new stock by the company. The formula includes variables for the price at which new stock is sold, the price at which the old preferred stock was sold, the total number of new shares issued and the total number of shares outstanding. There are two types of weighted average: narrow-based and broader-based. Formula can be tricky, ask a professional.
- Ratchet
Ratchet antidilution provision increases the conversion rate of the preferred stock based on the price per share at which the company sells its stock in a future down round, regardless of how few or how many new shares are sold at the lower price. This protects the current round of investors by allowing them to invest at the current moment, yet protected completely if future round is a down round.
Redemption
Redemption right allows investors to require the company to repurchase its preferred stock under certain circumstances, typically after a few years for the price originally paid. Redemption rights typically can not be exercised unless the holders of at least a majority request and usually cannot be exercised for four to five years after the financing.
Voting Rights
There are certain issues that company must obtain the approval of the preferred stock. Depends on the term sheet, each preferred series may have its own voting right and could vote as a separate class. This is one of the tools investors use to protect themselves from company management on important decisions such as asset sales, large capital expenditures, key management changes etc.
Dividends
Holders of preferred stock could receive cumulative dividend in addition to a liquidation preference. Typical dividend rate is between 5% - 8%. In general, investor does not expect to receive that dividend till liquidation event occurs. For example, if the preferred stock purchase amount was $10M, and the stock had a 1x liquidation preference and a 8% cumulative dividend. If the company was sold after three years, then the preferred stock holders would be entitled to $12.4M before anything was paid on the common stock.
Other Stuff
Of course, there are a lot more than what I put here on the investment. One of the great books on this is The Entrepreneurs Guide to Business Law. If you are an entrepreneur consider doing your startup, I would recommend this book highly.
If you are looking for strategic investments, you will see other items coming in from side letter. You can read more on I have several blogs on how you should look at strategic investments: Strategic Investment Structure I, Strategic Investment Structure II
Boundaryfree » Investment terms said,
September 7, 2006 at 1:21 am
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October 16, 2006 at 3:58 am
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James Cawley Axiom » Active market said,
May 25, 2007 at 4:15 pm
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August 7, 2007 at 8:15 am
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