The formulas, tricks and trade secrets of Private Equity

Liquidation Preference Participation

Sample Chapter

These are the juiciest of all term sheet topics because they tend to create the most misalignment between investors and entrepreneurs. Why? Well, for starters, to own preferred equity is to have a preference over ordinary equity, which implicitly creates misalignment. But there’s more, much more.
Investors often command preferred equity to gain protection on the downside. This protection is by way of their equity subordinating ordinary equity. So, if the company is wound up, the preferred equity holders receive payment before ordinary equity holders. (In most cases, there’s nothing left for ordinary equity holders.)
In addition to preferred equity subordinating ordinary equity, there are two other important considerations: preferred participation and liquidation preference. Preferred participation relates to an exit event where there is upside (it determines access to newly created value), whereas liquidation preference relates to an exit where there is downside (it reduces exposure to lost value).
Many instances of publicly listed preferred stock are non-participating. This means they don’t participate in the upside of ordinary stock. This lack of participation is accepted because the preferred stock is seen as debt since it includes a fixed periodic repayment and it subordinates ordinary stock (just like debt). So, like debt, it doesn’t participate in upside.
However, in private equity, preferred stock is usually fully-participating. That means that on an exit event (merger, sale, wind up, etc.), the preference equity converts to ordinary equity and gets full access to the upside. This is in addition to the fixed preferred dividend and the subordination rights. (Sometimes, the preferred equity with be partially-participating, which means that preferred equity holders will receive upside to a certain multiple of their original investment, but this is rare.)
As for the liquidation preference, it is a multiple that dictates the minimum return to preferred equity holders at an exit. So if the multiple is 1x (which it is 99% of the time) and I’ve invested $20m for 50%, then at exit I will receive at least $20m (if $20m is available). So, even if the exit event gives equity a value of $21m, I don’t just get 50% of that, but at least $20m. In effect, this creates a value decelerator for preferred equity; it can still be worth nothing, but it reaches nothing slower than ordinary equity.
You can clearly see that these preferred terms create significant misalignment with entrepreneurs whom hold ordinary stock. You often hear entrepreneurs say “why do you get all of the upside, but none of the downside.” The cheeky answer is “because we’re private equity”. The measured answer is that there is still downside; if the company is wound up and there is no equity value, then even the preferred equity holders are left holding the tip jar. However, that’s little consolation for entrepreneurs that have been taught by public equity markets that preferred equity is non-participating.
The answer to all of this is that these terms form part of an entire term sheet that needs to be prodded, poked and pulled in every direction until all parties feel comfortable. These terms allow investors to focus on certain aspects of a deal and entrepreneurs on others. For example, these terms can give entrepreneurs increased access to upside if they agree to take more exposure to the downside. It’s all about priorities.
These are the juiciest of all term sheet topics because they tend to create the most misalignment between investors and entrepreneurs. Why? Well, for starters, to own preferred equity is to have a preference over ordinary equity, which implicitly creates misalignment. But there’s more, much more.

Investors often command preferred equity to gain protection on the downside. This protection is by way of their equity subordinating ordinary equity. So, if the company is wound up, the preferred equity holders receive payment before ordinary equity holders. (In most cases, there’s nothing left for ordinary equity holders.)

In addition to preferred equity subordinating ordinary equity, there are two other important considerations: preferred participation and liquidation preference. Preferred participation relates to an exit event where there is upside (it determines access to newly created value), whereas liquidation preference relates to an exit where there is downside (it reduces exposure to lost value).

Many instances of publicly listed preferred stock are non-participating. This means they don’t participate in the upside of ordinary stock. This lack of participation is accepted because the preferred stock is seen as debt since it includes a fixed periodic repayment and it subordinates ordinary stock (just like debt). So, like debt, it doesn’t participate in upside.

However, in private equity, preferred stock is usually fully-participating. That means that on an exit event (merger, sale, wind up, etc.), the preference equity converts to ordinary equity and gets full access to the upside. This is in addition to the fixed preferred dividend and the subordination rights. (Sometimes, the preferred equity will be partially-participating, which means that preferred equity holders will receive upside to a certain multiple of their original investment, but this is rare.)

As for the liquidation preference, it is a multiple that dictates the minimum return to preferred equity holders at an exit. So if the multiple is 1x (which it is 99% of the time) and I’ve invested $20m for 50%, then at exit I will receive at least $20m (if $20m is available). So, even if the exit event gives equity a value of $21m, I don’t just get 50% of that, but at least $20m. In effect, this creates a value decelerator for preferred equity; it can still be worth nothing, but it reaches nothing slower than ordinary equity.

You can clearly see that these preferred terms create significant misalignment with entrepreneurs whom hold ordinary stock. You often hear entrepreneurs say “why do you get all of the upside, but none of the downside”. The cheeky answer is “because we’re private equity”. The measured answer is that there is still downside; if the company is wound up and there is no equity value, then even the preferred equity holders are left holding the empty tip jar. However, that’s little consolation for entrepreneurs that have been taught by public equity markets that preferred equity is non-participating.

The answer to all of this is that these terms form part of an entire term sheet that needs to be prodded, poked and pulled in every direction until all parties feel comfortable. These terms allow investors to focus on certain aspects of a deal and entrepreneurs on others. For example, these terms can give entrepreneurs increased access to upside if they agree to take more exposure to the downside. It’s all about priorities.

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