We are often involved with assisting companies raising capital, and these companies can be at various stages of their business life cycles. For example, a start-up company might be raising capital for a wide variety of reasons (such as hiring a sales force, product development, etc.) and a middle-stage company might be raising capital for a certain strategic venture or add-on acquisitions. One of the issues that can be overlooked in the process is the economic impact of the capital being raised when there is a “preferred return” associated with the capital.
The capital can come from a variety of sources, such as private angel investors, venture capital funds or private equity groups. Regardless of the source, most investors require a certain amount of return on their investment. This is usually known as the “preferred return” a company will see in the Letter of Intent or Term Sheet from the investor (as an aside, it is critical to review the Letter of Intent or Term Sheet with your advisor to ensure you fully understand the terms).
A “preferred return” can have many different characteristics. Two of the most common types of “preferred returns” are the “participating” preferred return and the “non-participating” preferred return. The “non-participating” preferred return is usually more beneficial to the existing founders/equityholders, whereas the “participating” preferred return is usually preferred by the investor. It is crucial to understand the fundamental difference and failure to do so can have a dramatic impact on the founders at the eventual exit.
A “non-participating” preferred return entitles the preferred investor to a return on the amount of capital invested, plus any accrued and unpaid dividends prior to a distribution to the common equityholders. Once the preferred investor has received a return of its investment, plus its accrued and unpaid dividends, the remaining proceeds are distributed to the common equityholders and the preferred investor does not participate in this secured distribution.
Please note the distribution scheme described above assumes that the preferred investor has not converted its equity into a common equity position. In most situations, the preferred investor will have the ability to convert its preferred equity into common equity (because in certain situations the holders of the common equity might receive more per equity holding than holders of the preferred equity).
A “participating” preferred return entitles the investor to a return on its investment, plus any unpaid and accrued dividends, which is the same as a “non-participating” preferred return. With a “participating” preferred return, however, after the investor receives such payment, the investor also participates with the common equityholders on an as-converted basis on the remaining available cash. This can sometimes be referred to as the “double-dip” because the investor gets to receive its money back (plus the dividends), and then gets a second distribution.
It is critical for a company raising capital to understand the differences of various preferred return distribution models. Depending on the valuation of a company at a sale, the difference in a “participating” preferred return versus a “non-participating” preferred return can have a drastic impact on the amount of proceeds the owners (both founders and investors) receive upon a company sale.
**This Legal Bulletin is for informational purposes only and not intended as legal advice for specific situations.