Cap tables can start to get complicated with just a few rounds of financing, so pro-forma and scenario analysis can get tricky. Here’s a breakdown of exactly how preferred stock works in different scenarios.

If you’ve raised venture money, then you probably have preferred stock on your cap table. But do you really know how preferred stock affects your equity? Even if your company gets a great valuation, you might be surprised when it comes time to cash out.

To avoid surprises and make informed decisions, founders and employees need to understand the mechanics of preferred stock. So here’s some of the most widely used preferred terms, what they mean, and how they play out in an exit.

Liquidation Preference

Almost every preferred security has a liquidation preference, which simply means that preferred stockholders have a right to get their money back before any one else. Preferences are usually expressed as a multiple of invested capital. If preferred stock has a “1x” liquidation preference, then preferred shareholders are entitled to receive an amount equal to one times their investment before other shareholders receive anything.

In most cases, if shareholders elect to receive their liquidation preference, they forgo their right to participate with the rest of the shareholders. This typically only plays out in a downside scenario, because preferred shareholders will choose to participate according their ownership (pro rata) if the company sells for a meaningful amount.

We’ll use a simple example to show how this plays out. Suppose I bought 500,000 shares of Series A stock for $1/share, and Series A has a 1x liquidation preference. Now let’s assume that you own 500,000 shares of common stock. Here’s what the cap table would look like:

Shareholder Series A Common % Ownership
You 0 500,000 50%
Me 500,000 0 50%

If the company sold for $750,000, my 1x liquidation preference entitles me to $500,000 of proceeds. This means there’s $250,000 left for you, even though we both own 50% of the company.

1x Liquidation Preference @750k

Liquidation Preference

Generated by Capshare.com

Now suppose that Series A has a 2x liquidation preference. I’m now entitled to $1 million of proceeds before you get anything even though I only invested $500,000. So in the same exit scenario of $750,000, I get everything and you get nothing. A liquidation preference of more than 1x is less common, but I’ve seen them a few times.

Let’s go back to our original Series A with a 1x preference and analyze what happens if the company sells for $1.5 million. If I chose to take my liquidation preference, I’d again receive $500,000, and you’d get the rest ($1 million). But in this case, I would choose to forgo my liquidation preference and instead split the proceeds according to our ownership (50/50). That means we both get $750,000.

Here’s a graph of the total distributions in all scenarios:

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Generated by Capshare.com

Why do investors want a liquidation preference? They simply want to protect themselves in a downside scenario. They’re taking on a lot of risk by betting on the entrepreneur, who may have little to no real money invested in the company, so it’s generally a fair tradeoff.

Participation Rights

If preferred stock has participation rights, that means that in addition to taking their liquidation preference, preferred stockholders also participate pro rata in the remaining amount to be distributed.

To illustrate, let’s use our same cap table from above, only Series A now has a 1x liquidation preference and participation rights. If the company sells for $1 million, my liquidation preference again entitles me to $500,000 right off the top, which leaves $500,000 left.

In this scenario, since I have participation rights, the remaining $500,000 is split between you and me based on our overall percentage ownership (50/50). This means I get an additional $250,000 and you get $250,000. So in total, I get $750,000; you get $250,000.

1x Liquidation Preference With Participation Rights @1M

Liquidation Preference With Participation

Generated by Capshare.com

As you can see, participation rights (also referred to as “double dipping”) can be pretty harsh. Why would investors get this kind of privilege? Some would argue that they shouldn’t, but I’ve seen it on plenty of cap tables. Whether or not this term is fair is the topic for another discussion. Our main stance would be that all parties should have an equal understanding of what’s going on.

Participation Cap

A participation cap is an extension of the participation rights we just discussed; it’s limit on the amount of proceeds an investor can receive from participation rights. This term is also usually expressed as a multiple of invested capital.

For example, if Series A has participation rights and a 3x participation cap, that means they can take their liquidation preference, then participate in the remaining proceeds pro rata until they receive an amount equal to three times their invested capital.

Continuing with our original cap table, let’s look at the breakdown if the company sold for $2.75 million. In this scenario, I would take my $500,000 liquidation preference, then I’d start to participate in the remaining amount pro rata. However, my participation is capped at 3 times my invested capital, so I would max out at $1.5 million in distributions. This leaves $1.25 million for you.

1x Liquidation Preference With Participation Rights and 3x Participation Cap @2.75M

Liquidation Preference With Participation Cap

Generated by Capshare.com

Things are starting to get a little complicated. With this cap table, I get all the proceeds from $0 to $500,000. Any proceeds between $500,000 and $2.5 million are split between us 50/50. Then you get all the proceeds from $2.5 million to $3.0 million. After that, I have to forgo my liquidation preference and split everything 50/50.

Here’s what a graph of the payouts would look like at various exit values:

Breakpoints for Participation Cap

Generated by Capshare.com

You can imagine how complicated it gets once you have many securities with different preferences on the cap table.

So what’s the point of participation caps? It’s basically a way for investors to protect their downside, take a little extra, then let common catch up if the company’s value exceeds a certain threshold.

Comparing Scenarios

Let’s make an apples-to-apples comparison of each scenario where the company sells for $2.75 million.

1x Liquidation Preference @2.75M

Liquidation Preference

Generated by Capshare.com

1x Liquidation Preference With Participation Rights @2.75M

Liquidation Preference

Generated by Capshare.com

1x Liquidation Preference With Participation Rights and 3x Participation Cap @2.75M

Liquidation Preference

Generated by Capshare.com

Modeling Your Own Cap Table

These terms are pretty straightforward to grasp, but modeling them out on your own cap table can be a little more difficult. Here’s where most people run into problems:

Getting The Cap Table Right

Keeping an accurate record of ownership can be quite a task, and many companies often have incorrect cap table data. Before you model any scenarios, make sure your cap table is correct and up-to-date. You don’t want to make important equity decisions based on incomplete or inaccurate data.

Finding The Terms

Finding out the terms specific to your cap table can be a challenge if you don’t know where to look. The easiest place to find what you need is the term sheet. Everything is usually spelled out with language similar to what we’ve used here. You can also look in the company’s articles of incorporation. There’s usually a section called “Rights, Preferences, and Restrictions of Preferred Stock” that contains a subsection on liquidation preferences. However, you might not find the exact phrases mentioned here, so you may have to translate from legal jargon.

Building The Spreadsheet

Modeling can get tricky as soon as you start dealing with convertible notes or multiple classes of preferred stock, not to mention options and warrants. Your spreadsheet can become a complex web of interlinking worksheets and cells, especially if you want to drill down by shareholder or analyze multiple scenarios.

This is probably where most founders have the biggest disadvantage compared to investors. Venture capital firms are managed and staffed by seasoned entrepreneurs, investment bankers and consultants who model cap table scenarios every day. Startups usually don’t have the expertise to build complex cap table models until they can afford a CFO.

So how can venture-backed companies navigate the complexities of venture finance and cap table management? We think we’ve built a pretty slick solution, but there’s no silver bullet that’s going to solve every problem. Ultimately, you have to learn by experience and seek advice from people who have been there. Learning from other people’s experience is a great way to make better decisions and avoid mistakes.

We’re always eager to help startups, so if you ever need help, feel free to hit us up on Twitter (@capshare) or send us an email.