Even savvy investors often don’t understand the subtle nuances on economic incentives that result from non-participating preferred stock or participating preferred stock with a cap in the event of a sale of company.
Assume a simple cap table of:
10,000,000 shares of common stock
10,000,000 shares of Series A preferred stock
Also assume that the Series A preferred stock has a $1.00/share liquidation preference and is non-participating.
If the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.
If the company is sold for $10M to $20M, the holders of Series A would still receive $1.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common. For example, if the merger consideration is $15M, then the Series A would receive $1.00/share and the common would receive $0.50/share. Thus, the holders of Series A are indifferent between sale prices from $10M to $20M, which may lead to odd economic incentives. Hypothetically, a venture capital fund holder of Series A might not want a company to argue hard over merger valuation with an acquiror if there is no marginal benefit to the fund and there is a risk that the deal may fall apart.
If the company is sold for over $20M, the holders of Series A would convert to common (assuming that they are economically rational). For example, if the merger consideration is $30M, then the common would receive $1.50/share (assuming all Series A converted). Of course, if some holders of Series A did not act in their optimal economic interest and convert, then the merger proceeds available to the common would increase and the common would receive greater than $1.50/share.
Similarly, if the Series A is participating with a cap, there will be a range of merger consideration values where the holders of Series A will be indifferent because the cap has been met, but it still does not make economic sense for the Series A to convert.
In the same example, assume that the Series A has a $1.00/share liquidation preference and is participating with a 3X cap.
Like the non-participating preferred, if the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.
For merger consideration greater than $10M but less than $50M, the Series A participates with the common on the amount over $10M. For example, if the merger consideration is $20M, the holders of Series A would receive $1.50/share, or an aggregate of $15M (which represents the $10M liquidation preference and $5M of participation with the common), and the holders of common would receive $0.50/share, or an aggregate of $5M.
If merger consideration is $50M, the holders of Series A would receive $3.00/share, or an aggregate of $30M (which represents the $10M liquidation preference and $20M of participation with the common), and the holders of common would receive $2.00/share, or an aggregate of $20M. At $50M, the Series A hits the 3x cap on participation by receiving $3.00/share.
If the company is sold for $50M to $60M, the holders of Series A would still receive $3.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common. For example, if the merger consideration is $55M, then the Series A would receive $3.00/share and the common would receive $2.50/share. Thus, the holders of Series A are indifferent between sale prices from $50M to $60M, which may lead to the same odd economic incentives as the non-participating preferred stock, albeit at higher transaction values.
If the company is sold for over $60M, the holders of Series A would convert to common (assuming that they are economically rational). For example, if the merger consideration is $60M, then the common would receive $3.00/share (assuming all Series A converted).
Please see the liquidation preference spreadsheet and program some examples if you want to proof this yourself.