The fallacy of Participating Preferred

Once in a while I see a startup that gave its Series A investors participating preferred shares. Not unexpectedly, this is more common with startups that raised money from Israeli VCs.

For those who aren’t familiar with how participating preferred shares (PPS) work, it’s a very simple structure: When the company exits (a liquidation event), the investors first get their money back AND then participate as though they owned common shares in the business. This is in contrast to non-participating preferred shares, where the investors can either get their money back OR participate as though they owned common shares in the business.

To illustrate, let’s assume an investor invested $5M at a $10M pre-money valuation to own 33% of the company, and the company later exited for $30M. If the investor had non-PPS then he would get 33% of the exit value, which is $10M. However, if the investor had PPS he would first get his $5M back and then 33% of the remaining $25M, resulting in a $13.25M return. As you can see, the investor increased his return from 2x to 2.65x just like that!

While PPS may sound like a great term for VCs, in most cases it will end up disadvantaging early stage investors. It is very common in subsequent financing rounds for new investors to get the same terms that previous investors had. So when the series A investor asks for PPS, he creates a precedent for the following rounds which will get it as well.

However, the interesting thing about PPS is that they mainly impact returns in the low to middling outcomes.  Moreover, since later rounds tend to be larger and at higher valuations, their investors benefit more from PPS on account of the early stage ones (and the founders). To illustrate, let’s look at the extreme case of a series A investor investing $5M at a $10M pre money valuation to own 33% of the company, and series B investor investing $100M at a $900M pre money valuation to own 10% of the company. Now assume the company later exits for $1B. If the investors had non-PPS then the series A investor would get $333M (33% of $1B) and series B VC would get $100M (10% of $1B). However, if they both had PPS then the series A investor would first get back his $5M and the series B his $100M. Then the series A investor will get 33% of the remaining $895M, which results in a $300M return (instead of $333M with non-PPS), and the series B investor will get $189.5M (instead of $100M). As you can see, the series A investor would have been better if he didn’t ask for a PPS.

(Note that in order to simplify the math, I didn’t take into account the dilution effect of series B on Series A since it doesn’t change the basic concept.)

In reality, this is even worse for early stage investors since most PPS are capped. Therefore, in many outcomes the series A investor hits his cap while the later stage investors keep benefiting from the PPS structure.

I don’t know if and why this simple math escapes several series A investors. But if you are raising a series A (or seed round) and your investor is asking for PPS, please ask them to think twice.

3 thoughts on “The fallacy of Participating Preferred

  1. Thanks for the article!
    It’s simple math although while during negotiations it’s hard to think of it.

  2. Hey Amit
    Totally agree with the premise that PPS can harm investors as well as founders. I’m missing thought something in your calculations:

    Why would the Series A investor in the second example (non PPS) get 33% of $1Bn = $333m? Don’t they get diluted in Series B which means their 33% decreases to 30%, thus getting $300m?

    Similarly, in the PPS case, the Series A should get back their $5m (not $10m), Series B their $100m. Then the remaining $895m splits 30% (not 33%) to Series A ($268.5m) and Series B gets their 10% ($89.5m). In total Series A will get a meagre $278.5m (not $303m) whereby Series B will get $189.5m.

    Let me know if I’m missing something in the calculations above.

    1. Thanks Oded! You are right about the $5M in the second example, I updated the post.
      Your math is correct regarding the dilution effect of Series B on Series A. I intentionally didn’t take it into account since it doesn’t change the basic idea I am trying to convey and I was worried it will over-complicate the main message. I added a note to clarify this.

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