A Deeper Dive into Preferred Share Rights in Venture Capital-Backed Firms (VCBFs)

I’ve been thinking…Why do VCs use preferred share rights in negotiating investments in a VCBF?

Investing in securities of a startup firm is extremely risky, and the VC funding model has developed a set of strategies that seeks to reasonably mitigate VC investment risks without unreasonably thwarting the original motivations of the startup’s founder to seek VC funding.  Over the years, the VC industry has honed its funding model and evolved a common set of preferred share rights to reasonably deal with the perceived investment risks at each stage of investing in a startup.

In my opinion, a large part of the success of the VC industry can be attributed to the effective use of a regime of preferred share rights.  In short, this regime allows the VC investor to continue to invest beyond the Series A round by negotiating for risk-appropriate changes to the terms of certain preferred share rights in subsequent rounds.  For example, at the time of negotiating the Series B and C rounds, the VC investors have a deeper understanding of the historical performance of the VCBF and can base assessments of future prospects on such past performance as well as the impact, if any, of relevant current market conditions.  This blog will take a deeper dive into a selective set of commonly used preferred share rights.

The actual investor in a startup’s securities is a specific VC fund, which is affiliated with and operated by an associated VC firm.  The money in the VC fund is raised by the VC firm and is overwhelmingly provided by institutional investors, such as pension funds. The business model of a VC fund can be simply stated: buy low, sell high.  The organizational structure used in the typical VC fund is a limited partnership, with the VC firm acting as the general partner and the institutional investors acting as the limited partners.  The VC firm not only raises the money for each of its affiliated VC funds but also sources and vets the potential VCBFs and negotiates the terms and conditions of an investment on behalf of the investing VC fund.  The VC fund pays the VC firm an annual management fee, often 2%, and a percent of any profits, which is known as a carried interest and is often set at 20%.

In general, before the first funds are released in the Series A round by the VC funds, the affiliated VC firms have performed a reasonable due diligence investigation.  That investigation serves as the basis for negotiations with the VCBF over the terms and conditions of the Series A round, which will be memorialized in a preferred rights agreement for Series A shares.  The process is repeated for subsequent investments in Series B and any future VC-led investment rounds; however, the Series B round, for example, has its own set of investment documents, including preferred shares rights for Series B shares.

The VC investment vehicle of choice is convertible preferred shares, which are convertible to common shares.  The timing of the conversion right is up to the VC shareholder but is often linked to a so-called exit event, such as an IPO or merger of the VCBF.  In my experience, the conversion ratio in Series A shares is negotiated at 1:1.  Thus, the exact terms of the exit event will determine whether or not the Series A shares will be converted.  If the exit event price per share is higher than the Series A price, then the preferred shares will be converted.

If the exit event price is lower than the Series A price, then the VC investors will avail themselves of another commonly negotiated preferred share right: liquidation preferences.  This right assures that, upon liquidation of the VCBF, the cash proceeds are first paid out to the VC investors in accordance with the terms negotiated in the Series A shares.  In my experience, the liquidation preference is expressed at the multiple of the amount invested, typically 1x for Series A shares.  If the VCBF is not meeting expectations, the negotiations for subsequent rounds of financing can result in an increase of the multiple for Series B or C, for example.   On the other hand, if the exit event is an IPO, it is often the case that the Series A shares provide for a so-called double dip: fully participating in the IPO and retaining the liquidation preference payout.

Before investing in the Series A round, the issues of board of directors representation and information rights must also be negotiated.   Negotiations with VC investors over these two issues can be a wakeup call to founders that accepting VC funding carries with it fiduciary responsibilities to others.  In my experience, founders must agree to reconstitute the existing board membership and adopt new procedures.  For example, founders are limited to one or two seats.  Formal board seats are allocated to the lead VC investor, who often acts as chair.  In some cases, more than one VC investor will join the formal board, while still other VC investors are allocated so-called visitation rights, which allow for board participation but preclude the right to vote.  The few remaining slots on the board are saved for individuals with so-called domain knowledge of the VCBF’s business.  The board is required to hold regular meetings and use a pre-circulated agenda that typically includes a so-called board reporting package detailing the VCBF’s operating and financial performance.

In my experience, the reconstituted board’s singular focus is creating value at the VCBF.  At each board meeting, this translates into closely analyzing progress against plan of the VCBF’s identified value drivers.  Identifying milestones as well as monitoring cash burn and future funding needs are among the topics relentlessly scrutinized at each board meeting.   I’ve heard it said that some founders view the in-depth level of questioning of certain board meeting subjects as a contact sport.

In general, investors in the Series A round expect that the preferred share price of the Series B shares, for example, would be higher than the Series A price.  This is known as an “up round.”  If the Series B price is less than the Series A price, known as a “down round,” the Series A investors are protected by the anti-dilution protection right negotiated in the Series A round.  In its most common form, known as a “full ratchet” protection, the full amount of the Series A investment is recalculated at the Series B price, resulting in additional shares being issued to the Series A investors and further diluting the founders’ ownership in the VCBF.

In corporate finance, investors in preferred shares have the right to receive a stated annual cash dividend.  In VC finance, dividend rights are negotiated in the Series A round (and in each round thereafter), but cash dividends are not part of the VC funding model.  In my experience, negotiations involve whether or not the agreed-upon amount of annual dividends is cumulative or non-cumulative.  In any case, any dividends due are settled at the time of the exit event and are paid through the issuance of additional shares rather than in cash.