2 massive traps that even experts struggle with when negotiating preferred shares

Trap #1: Unfavourable Anti-Dilution Protection. Often, especially younger companies, requiring additional equity to grow to a stage where they are self-sufficient, will concede a substantial share of their company. They accept extensive anti-dilution protection mechanisms of preferred share offerings in the quest of making their dreams come true. This is typically based on the belief that they will not need additional money, rendering the perils of extensive anti-dilution provisions ineffective.

Why is this a trap?

More often than not, these companies do end up needing additional funds, because of delays or additional costs to execute the patent strategy, or for various other reasons. In the next fundraising round, the common shareholders (founders, friends and family, employees) may be diluted extensively, as they lack the anti-dilution protections the preferred shareholders enjoy. This may even lead to the common shareholders being reduced to a minority, losing control, and, eventually, to the preferred shareholders forcing a sale of the company against the will of the common shareholders.

Trap #2: Unfavourable Liquidation Preferences. For the same reasons as outlined above, common shareholders may accept preferred shares with unfavourable liquidation preferences, for example, full participating preferred shares with a, say, 2x multiple. As an illustration of the negative consequences of these terms, let’s run through an example: Assume you have sold your company for $15 million. There are no creditors, and no unpaid dividends. The preferred stock financing was for $5 million for 50% of the company. Corresponding to your 2x multiple, the preferred shareholders now receive $10 million (two times their investment) plus, in accordance with their 50% ownership, another $2.5 million of the remaining $5 million, for a total of $12.5 million, or 83% of total proceeds, for their 50% ownership. By contrast, the common shareholders collect just $2.5 million, or 17% of total proceeds, for their 50% ownership.

Why is this a trap?

When negotiating the preferred shareholder agreement, the common shareholders will likely not envision that an event triggering such liquidation preferences may happen, which will force the shareholders to share proceeds according to the agreed upon formula. Aside from liquidation, such events are commonly dissolution, merger or change of control. As outlined in trap #1, preferred shareholders’ extensive anti-dilution rights may lead to the preferred shareholders forcing a sale of the company against the will of the common shareholders. Of note, the preferred shareholders may not be as sensitive to the price at which the company is being sold, due to their favourable liquidation preferences, possibly leaving the common shareholders with little money and shattered dreams.

In my next post, I will explain how to avoid the 2 massive traps that even experts may struggle with when negotiating preferred shares as a way to raise equity.

For more detailed information about these traps and equity financing in general, see The Decision-Maker’s Guide to Long-Term Financing – available here.