Dealing with Preferences
The outcomes of negotiations around preferences never seem to have a compelling logic. Under a particular set of circumstances is there a compelling reason why the A and B should be equal (pari passu, as lawyers like to say) in the preference stack or one (usually the B) should be ahead of the A? It seems to me to be more determined by how eager to invest the new money is (or how desperate to get a next round the old money is). This “you get what you negotiate” situation probably accounts for why there are a wide range of provisions out there.
Having said that, there do seem to be some broad buckets that the outcomes fall into.
An Up-Round Scenario
Let’s look at a situation in which the B comes in at a significant increase in valuation compared to the A. In this situation, the valuation of the company starts off at a point higher than that aggregate of the existing preferences. If the company were to be sold in the following nanosecond, the B would get its money back and the A would get its money plus, perhaps, some return. The same result would obtain if the valuation increased over time.
If, however, the valuation declines over time, and the company is later sold for a valuation below that at which the B invested, then all investors would be at risk of not getting their investment capital back. If the B is equal to (or – God forbid – below) the A in the preference stack, the B would, in effect, be funding the A’s preference. For example, if the company were sold at a down valuation shortly after the investment, the A might likely be paid in full and the B might likely receive a reduced return – in effect the B’s money would have gone to pay the A. New investors (the B in our example) are very unlikely to be willing to do this, unless they are truly eager to get into the deal.
For this reason, the most typical arrangements in up rounds are for the new money to either have a priority over the old money or to be equal to the old money in the so-called preference stack.
A Down-Round Scenario
Now, let’s consider a situation in which the B comes in at a significant decrease in valuation from the A round – a down round. For the reason described above, it is hard to imagine that in this scenario, the B would agree to be anywhere other than at the top of the preference stack. So, let’s assume that is a given.
How will the B feel about the A keeping any preference?
The debate will center around how much, if any, of its preference the A should keep. To focus the issue, let’s assume that there was a really large A round (more likely there have been several early rounds and the new round is the D) and the old preferences add up to a large number, say $50 million. If the B invested, say $10 million and the A keeps all of its preference, then the company would have to be sold for more than $60 million for the B to start to see a return on its investment (not taking into account anything for the common). No new investor will agree to that structure in a down round situation.
So, the question is: What happens to the A?
When the A does not participate
In a down round where the A does not participate in a meaningful way in the new investment, the A holders have very little leverage. Their bargaining position consists of either holding the deal up altogether, at the risk of watching their entire investment disappear or making a huge concession to the B.
When all the A participate in an inside round
When all the A participate (without an outside investor), then the question becomes how much can reasonably be stacked on top of the common (typically meaning management’s options) before there is just no incentive for management to stay with the company. If it is necessary to reduce the aggregate preference that is stacked on top of the common, they can go ahead and do so by amending the A. In the alternative in a case where there is significant common ownership by persons no longer with the company, the investors may leave the preferences in place but create a management incentive plan that carves out some portion of exit proceeds to be distributed to management. (This, of course, has its own complexity. If management has an incentive plan that sits on top of the preference stack, it can affect management’s motivations. Which suggests another blog topic: How to structure management incentive plans to properly align management’s motivations, a topic for another day.)
The Cram down and the Pull-Through: when some, but not all, of the A participate
When some of the A participate and some do not, the negotiation can get interesting. The ones that participate (particularly if they lead and comprise substantially all of the B round) will be in a pretty strong position to hold onto their position in the preference stack. But, free riding by the non- participating A investors will be anathema to the participating investors.
Often the result of this situation is the pure cram down. The non-participating A investors end up converted into common stock (sometimes a pay-to-play is used to convert them into a preferred “lite”).
Sometimes, however, the new investors are willing to leave the non-participating investors with some preference over the common (and presumably over the profit potential to (as opposed to the return of invested amounts) the participating investors). Having observed this dynamic on a variety of occasions, I can’t say that I have seen any pattern to when it arises. One situation that seems to have some logic to it is when some of the A round investors were the sorts of angel and early stage investors whom nobody expected to see invest in later rounds. Another situation that I have seen arise is when some of the early round investors were brought in by the larger VC investors or are persons with whom the larger VC investors have ongoing relationships.
In these situations, you sometimes see a so-called “pull through”. It works like this: for every $XX of B that an existing investor buys, he gets to convert some number of shares of A into shares of B. In this arrangement, the B is ahead of the A in the preference stack.
The negotiation of all this is usually done among the investors and away from the sight of the company and management. Actually, it may be even more arbitrary than that suggests. It is often discussed among a small “inner” group of investors, who try and guess what they think it will take to get the deal done. When they finally come out with the offer, it is often a self-fulfilling prophecy. They are often so invested in the solution they propose that it is impossible to get them off it, with the result that it becomes their offer or nothing.
However, how the preference stack works can affect exits. At certain price ranges some investors at the top of the stack will get a return (or perhaps their bait back) while others will get nothing. As a result, there may be very different opinions around when and at what price investors will support an exit.