Term Sheet 101: Preference

Nearly all VC’s use convertible preferred stock as their vehicle of choice. Most entrepreneurs know this but many don’t fully understand the different flavors and elements of it.

Preference refers generally to the seniority of a given class of stock versus others. Preferred A stock usually gets paid back before common and follow-on Preferred issuances (B, C, D, etc) usually have seniority over both the A and common. This means that the investors will get their capital out before the entrepreneur and team usually.

There are two primary forms of Preferred stock: straight and participating. Straight convertible preferred stock is an either/or situation. Investors can opt to get their capital back but not participate in further upside (e.g. stay as preferred stock…usually the election in downside scenarios) or they can convert to common and participate alongside management & the entrepreneur. The kick point of this conversion is usually pretty clear. If an investor has put $10m in and has 10% of the company, for any exit that values equity above $100m, they will convert to common. For any exit below, they will stay as preferred.

With participating preferred, investors first get their initial capital out and then participate as common shareholders. So, in the above case, at $100m, the investor would get his/her $10m back and then would get an additional $9m (10% of the remaining $90m). Investors will often use this to hit return targets when having to pay a high initial price.

Some term sheets will include participation multiples where investors get 2x or 3x their capital out before other classes. This usually happens when there is significant preference (invested dollars) in the company and there is gap between when their get their capital back and when they start to participate in the upside.

Dividends also play a role in preference. There are cumulative dividends and “when & as declared by the board” dividends. With cumulative dividends, investors “preference” grows each year at a set rate (say 6%), thereby providing an ongoing discount for the investor. This dividend begins to kick in day one. Other dividends start only “when & as declared by the board”. I have not generally seen many boards vote to trigger a dividend.

New preferred stock can be either senior to previous preferred classes (say the Pref B gets its money before the Pref A) or it can be “pari passu” to them (the Pref B and Pref A have the same seniority and come out pro-rata based on their relative sizes). This term usually does not affect the entrepreneur who is subordinated to both classes but is an investor group matter.

As market conditions tighten, investors look to offset increasingly rockier environments through more aggressive terms. As they get more competitive, terms trend more loosely. Lastly, while earlier investors may lock in strong terms, everything is up for renegotiation when new investors come in. Previous preferred terms can stay in place or, in severe cases, get pushed to common. Participation multiples can be eliminated as can dividends. However, for entrepreneurs looking to use new financings to recut their deals, they should be careful. Earlier investors usually have blocking rights on new capital coming in. Additionally, entrepreneurs that play the sides against the middle (old vs. new investors) will significantly impair their relationship with initial investors if they blatantly play this card.

Preference takes many forms in venture capital. It is critical that entrepreneurs fully understand the implications of the terms they are accepting so that it does not impact future relationships going forward.

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