Securities typically used by Venture Capitalists are usually structured to:
1. Return invested capital to VCs in case the business fairs poorly and valuation does not grow
2. Reward the entrepreneur in case the business performs very well.
The above outcomes can be designed used convertible formats of Preference Shares.
Venture Capitalists and Angel investors typically use complex versions of Preference Shares to invest in companies. A Preference Share is a form of equity share but it more senior in a company’s capitalization as compared to Common Equity shares. Preference Shares are also used in convertible formats in complex transactions. Common Equity shares are the most basic form of equity ownership in a company. A Preference Share is therefore sometimes used to convert to certain number of common equity shares subject to certain conditions being met. Commonly used types of Preference Shares format that are used by Angel investors, Venture Capital firms and Private Equity firms are mentioned below.
1 CCPS – Compulsorily Convertible Preference Shares
One commonly used mechanism for this is the CCPS – the Compulsorily Convertible Preference Share. This is used widely in Venture Capital and Private Equity transactions around the world. Because a Preference Share is senior in the capitalization table, CCPS investors ask for a structure wherein if a company’s performance deteriorates, the CCPS remains as a Preference Share thereby providing seniority in the capitalization table. If however, the company delivers a reasonably strong performance, then the CCPS can convert Common Equity shares in the company.
2 PPS – Participating Preference Shares
Participating Preference Shares are Preference Shares that also have a Participating feature. A Participation feature allows the investor to not just receive the intial investment back but also receive a proportion of profits. As an example, consider an investor invested USD 1 Mn in a company and obtained PPS securities that had a Participating feature of 1x and 15% participating feature. Now assume that the company gets sold for USD 10 Mn. Upon exit, the investor will receive USD 1 Mn and then 15% of the remaining equity amount, ie, 15% of (10-1), ie 15% x 9 = 1.35. Therefore the total return made by the investor will be 1+1.35 = 2.135 Mn. These securities are usually used when there is a gap in valuation expectations between the investor and the company. When these securities are used, usually the stake that is given as part of the Participating feature implies a very high valuation. This structure protects the investor for lower valuation outcomes and rewards the entrepreneur for higher valuation outcomes. Therefore, an implied incentive mechanism is built in as part of the PPS securities. We can see this in an example.
Lets continue to use the same example discussed above. Lets assume that an investor can make one of two offers to invest USD 1 Mn in a company:
(a) invest with a liquidation preference of 1x and 15% participation
(b) invest simply with 20% common equity ownership. This implies that the company is valued at USD 5 Mn upon entry
For different sale values of the company one can see the exit value made by the investor.
As one can see in the above chart, for lower exit values, the investor walks away with a better outcome using a PPS rather than a straight 20% common equity ownership. For very high exit company valuations, the investor gets a lower outcome as compared to having simply 20% ownership. Investors are ok with this type of outcome range since in the VC world it is critical to get back invested capital amount in case an investee company is not performing well.
There are some other features that can be further added to the above structure. For example, one feature that is added is sometimes called a ‘cap’. For example, a cap of 4x stipulates that upon exit, if the investor gets 4 times the invested capital, then the liquidation preference is removed and the investor gets only the participation feature. This is because a 4 times return is considered as a good outcome for the investor and so the investor is willing to forego some extra return so that the entrepreneur is further incentivized for making the business excel.
(3) Redeemable Participating Preference Shares (“RPPS”)
This is a very frequently used investment structure in western markets and is similar to the PPS structure described above. The main difference is that in this structure, once the company ‘redeems’ the investor and pays back the investment amount then only the participating feature remains. Lets see this through an example. Lets once again consider the example taken above where an investor provides USD 1 Mn to a company with 1x Liquidation Preference and 15% Participation. Lets assume the investor received RPPS securities. In this case, once the company pays USD 1 Mn to the investor then the RPPS securities simply convert to a new economic structure where they have 15% ownership in the company.
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