The art of venture investing: navigating the complexities of preferred equity

Why should founders carefully consider preferred equity rights? 

When given the choice between ordinary equity and preferred equity for the same price, a savvy investor would choose the preferred equity because it offers more protection against downside via the liquidation preference and potential gains through pro-rata share of upside.

It is important to acknowledge that this value protection is implicitly provided to preferred equity by the ordinary equity. Therefore, it is important for founders to carefully consider the terms of the investment and negotiate to protect the value of their equity and the equity of their employees.

How does preferred equity impact investor returns?

When a recent raise is available, it is convenient to assume this can easily be used to deduce a broader business value, which is commonly referred to as the post-money valuation. However, a challenge emerges when using the price of preferred equity and ascribing the same value to the ordinary shares. This is because the pricing for preferred equity reflects its preferential terms, and changes in business value can impact preferred and ordinary stock differently.

Without a full assessment of these differences and their impact on value, it is easy to assume that either: 

1. Where value increases: Changes in business value translate directly to the preferred equity (e.g., if the business value of a company doubles, investors may assume that the investment in preferred and ordinary shares doubles).
2. Where value decreases: Downside protection is more than it actually is (e.g., if the business value decreases by half, the investor may assume that they hold preferred equity with a liquidation preference, and the impact should only be on ordinary shares).

However, neither of these positions is correct. There is more nuance to how the impact of business value change translates to the value of each class within a capital structure (especially in the presence of multiple classes of preferred equity with different rights):

1. Where value increases: All share classes with a right to a share or equity upside will benefit. However, preferred equity with a higher liquidation preference might have a lower percentage return on investment than lower liquidation preference shares or ordinary equity.
2. Where value decreases: All share classes with a right to a share or equity upside will be affected. The downside to preferred equity will be less due to the downside protection provided by the liquidation preference.

Investors and founders should carefully review the terms of preferred equity to make informed investment and reporting decisions, as the specific terms can vary and impact performance differently.

Timing matters!

Preferred equity has rights that may impact the value of the business and ordinary shares, but these rights usually only come into play at an exit event or in a liquidation.

For instance, if an investor holds preferred equity with a liquidation preference of $1.0 million, and the business value falls to $1.0 million, the investor may assume that the entire value of the business belongs to them. However, the value of the business will not be allocated to preferred or ordinary shareholders until the business is liquidated or sees a successful exit event, which might be a few years away. During this time, the business has an opportunity to grow in value (which may lead to a value being allocated to the ordinary shares at the exit event) and conversely there is risk that value will fall further (and the liquidation preference will not be returned).

This structure of preferred equity gives ordinary shares an option-like payoff where they get nothing if the value of the business at exit is lower than the liquidation preference, but they get upside if the value of the business is higher than the liquidation preference at the exit event date. As a result, even if the value of the business has not yet grown above the liquidation preference, there is still value to the ordinary equity associated with future value upside. Investors who overlook the timing of rights allocation for preferred equity may undervalue ordinary shares.

By carefully considering the nuances of preferred equity, investors can make more informed decisions and have more accurate reporting.

Additional considerations for informed decision-making

When negotiating, early-stage investors and founders should be aware of provisions that can significantly impact value of their holdings. As some examples:

• Structuring of nature of preferred terms: Some preferred equity has provisions where an investor can recoup their initial investment as well as a pro-rata share of equity proceeds. This may leave less return for the early-stage investors and founders. Consider our earlier example but a derivation where an investor investing $1.0 million in preferred equity can select from either:
  1. A liquidation preference equal to their invested capital (received in any exit scenario) and a pro-rata share of equity proceeds over this.
  2. A liquidation preference equal to their invested capital (received only if the shares are not converted to Ordinary equity) or otherwise a pro-rata share of equity proceeds.

In a successful sale of the business, the returns derived by each of the shareholders will reflect these terms, with some examples summarised below:

Scenario 1

Scenario 2

• Preferred return greater than 1x: Where risk is perceived to be a higher, investors might ask for 2x or 3x liquidation preferences (meaning they would receive multiples of their original investment before ordinary and existing preferred shareholders are paid). 

From the above examples, you can see that agreement of a seemingly small change can have a significant impact on proceeds on exit.

The American Institute of CPAs (AICPA) and International Private Equity and Venture Capital Valuation Guidelines (IPEV) have issued guidance to harmonise views of industry participants, auditors, and valuation specialists. These guidelines suggest that amounts accruing to each financial instrument should be reflected and liquidation preferences should be reviewed for impact on investment value.

Some of the method suggested by these guidelines are:

1. Current Value Method (CVM): Allocates equity value to different classes of preferred equity based on their liquidation preferences or conversion values as at today. This is appropriate when a liquidity event is imminent.
2. Option Pricing Model (OPM): Models the expected future cash flows of the enterprise and the expected future payoffs of the different classes of preferred equity using OPM. Appropriate when the future of the enterprise as a going concern is relevant.
3. Scenario-based Method: Involves creating a range of explicit future outcomes for a company and assigning probabilities to each outcome. Useful when valuing equity interests in a portfolio company that is expected to have an exit event in the near future.
4. Fully Diluted Method: Assumes that all classes of shares are the same (which may not always be the case) and references either a pro-rata share of an overall equity value of a recent preferred equity raise price as the price of all classes. This is sometimes used as a simplified assumption where the value of the business has significantly exceeded the liquidation preference and there is no meaningful expectation that the liquidation preference will be used. This is unlikely for a business that has recently raised capital and is likely to misrepresent the value of differing classes of equity. This method may be suitable in rare scenarios, such as a business that expects bi-modal exits where there is only a probability of liquidation with a minimum value left for existing investors, or a successful exit (e.g., IPO) that treats all shareholders in a similar manner.

Consideration of each approach and which is relevant given the facts and circumstances of the investment being held is key to ensuring that an appropriate valuation is derived.