Rather limited exposure to the world of VC, so forgive the elementary question. When a VC investor goes into a, say, Series A round, he gets preferred shares. Let's say he gets a 1x liquidation preference, and no participation rights.
Where does his return come from? 1x basically means he gets his money back. And because there are no participation rights, he doesn't get the 1x and then the opportunity to participate as a common shareholder, right? In actuality, do preferred investors typically get participation rights? Or do preferred investors usually have the right to convert their shares to common once the return to common > their cost/share?
Insight here would be appreciated.
Thanks! BR
Here's the answer. VC terminology sounds more complicated that it really is.
Preferred shares are senior to common and usually have an annual dividend (although most times the dividend just accrues and gets paid on exit). In an exit scenario preferred shares receive their initial investment + dividends.
Participation allows preferred shares to also take their pro rata of exit value. So as an example, if I invested $10M in a company and own 10% of it (so, 100M equity value), and it exits for that amount, I first receive back my $10M and then 10% of the remaining exit value ($90M in this case). This of course, assumes I am the only preferred investment.
1x liquidation preference means that as preferred, you are entitled to receive 1x your initial investment in an exit scenario. However, if the exit is at a valuation higher than where you invested (which is always the hope), then you have the option to convert your shares into common, and thereby participate at your pro rata and receive more than 1x your initial investment. So in the above example, if I had just straight preferred with no participation and the company in question exits at $50M, I would not convert, because 10% of $50M is less than my initial investment. However, if the company has a $200MM exit, I would convert, because 10% of $200M is $20M, which is 2x my initial investment of $10M.
Hope it's helpful.
SB for thoroughness and accuracy, which probably saved several of us a few minutes.
Definitely a SB-worth answer.
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