Uncapped participating preferred prevalent on the West Coast

Participating preferred are very often a sore topic of discussion with entrepreneurs who point out some perceived "immoral" characteristic as they provide the venture capitalist with a "double dip" i.e. two bytes at the cherry.  Many Euro entrepreneurs will argue that "in the Valley (a.k.a the Bay Area), you just don’t see that kind of stuff".  Recent data from Fenwick and West suggest that may be wrong. 

A.  Quick layman’s primer on participating prefs

For those not familiar with the concept, participating preferred are such that upon an exit event, the exit proceeds will first go to the venture capitalist, and once the VC has received its money back, than to all shareholders ratably… including the VC.  Hence the double dip monicker.

Personally, I like to negotiate my term-sheets based on logical rationale rather than brute economic force, since "one has less trouble accepting what one can understand".  Many entrepreneurs have seized upon this over the years in attempts to negotiate away the double dip.  I usually defend this rather simply on the basis that (a) I am trying to move their "wealth" point (the equity value number at which there is a serious cash out event for the entrepreneurs) further out to make sure they create enough value for the investors before exiting and (b) I am simply improving my return profile, since they do not want to agree to my ownership target :-).

A common compromise is to agree a cap on the double dip.  For example, the double dip would apply up to a 4X return threshold for the VC, followed by a straight line amortisation between the 4x and 5x return points to bring the founders back to pro-rata.  That way VCs protect the return in mid-range scenarios but the entrepreneurs don’t feel screwed on the upside.  This is a factor of complexity as few people really grasp the calculations and you end up having to produce exhibits to show what the proceeds are at which price level.  All the while you could have been closing a new investment !!  and My personal view is that less is more when it comes to legal complexity.

After writing this I will also point you to the man for a more detailed discussion.

B.  Is Valley grass really greener ?

The Bay Area has always captured our imagination as the best place to start a new company, and rightly so.  But fascination with the region’s ecosystem should not go too far.  Yes, driving down 280 is a unique experience, but local VCs drive a hard bargain too, as evidenced below.

Fenwick and West are a great legal outfit on the West Coast (I can recommend Bill Schreiber who did a superb job as counsel of Inxight Software) and publish an extremely useful "Trends of Venture Financings" in the SF Bay Area" which you should all subscribe to.  Jeff Clavier does a good overview as usual if you want the headlines.

I wanted to zero-in on the following stats:

  • 71% of financings provided for participation in Liquidation
  • Of those, 64% were not capped

In other words, 71% of deals involve a participation and 45% of all deals are uncapped participating.  What I am missing of course is the all-important definition of Liquidation, which tends to be company specific and can be key (clue: when is a sale not a liquidation ?).  However I think the numbers are fairly eloquent and should help all of us to take a more holistic view of what "market terms" really are when it comes to participating preferred.

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