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

As you may recall from my last post on August 25th, the 2 massive traps are:

Trap #1: Unfavourable Anti-Dilution Protection

Trap #2: Unfavourable Liquidation Preferences

Here is how to avoid these traps:

More about Trap #1 - Anti-Dilution

Preferred share provisions almost always include dilution protection from new share offerings, allowing ownership percentages to be maintained. Sometimes, depending on the perceived risk, investors will also demand to be protected against future issuances of shares at a price that is lower than the price paid by the preferred shareholder. This is frequently negotiated in venture capital financings; it is known as a “price-based anti-dilution provision in down rounds.” There are two basic forms:

- Weighted Average Adjustment – Here, the price at which the preferred shares can be converted into common shares (conversion price) will be weighted by the shares that are being sold.

- Full Ratchet Adjustment – In this less company-friendly alternative, the conversion price will be reduced to the price at which the new shares are being issued, no matter how many shares are being sold.

How to Avoid This Trap: If possible, common shareholders should avoid the full ratchet adjustment, as it can be exceedingly dilutive to their shares. If avoidance is impossible, negotiate a time limit. One year may be an acceptable option.

Alternatively, there may be other (new) financing alternatives accessible to you, such as crowdfunding or the sale of non-dilutive, revenue-based royalties.

More about Trap #2 - Liquidation Preference

The liquidation preference determines how the company shall distribute proceeds from certain specified events, commonly liquidation, dissolution, merger or change of control. There are three forms:

- Non-Participating Preferred Stock - In this scenario, preferred shareholders are entitled to the return of their whole investment, plus accrued dividends, before any remaining proceeds are being distributed to the common shareholders. This liquidation preference is most favourable to the common shareholders.

- Full Participating Preferred Stock - Once the preferred shareholders have received their whole investment, plus accrued dividends, they share equally, on a pro rata basis, with the common shareholders of the remaining proceeds, as if the preferred shareholders had converted their shares to common shares. In other words, the preferred shareholders participate twice. This liquidation preference is most favourable to the preferred shareholders.

- Capped or Partially Participating Preferred Stock - Once the preferred shareholders have received their whole investment, plus accrued dividends, they share equally, on a pro rata basis, with the common shareholders in the remaining proceeds, but only up to a certain amount.

Preferred share investors will also sometimes negotiate a “multiple,” whereby they are entitled to a multiple (2x, 3x, and so on) of their investment plus accrued dividends before any remaining proceeds are distributed to the common shareholders. This is favourable to the preferred shareholder and is the least favourable to the common shareholders.

How to Avoid This Trap: Stay away from full participating preferred stock, and avoid scenarios whereby the preferred shareholders are entitled to a multiple of their whole investment before remaining proceeds are distributed to common shareholders.

Again, even for earlier stage companies, there may also be other (new) financing options available, such as crowdfunding or the sale of non-dilutive, revenue-based royalties.

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