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The section about "Underwater Options" is describing what would happen assuming a Participating Liquidation Preference. It's a little misleading, because the va
by SeoxyS 11y ago
The section about "Underwater Options" is describing what would happen assuming a Participating Liquidation Preference. It's a little misleading, because the vast majority of liquidation preferences nowadays are non-participating. It's an important distinction.
A 1x non-participating preference means that before anyone is paid out, the investors get their money back. The remainder, if any, is distributed pro-rata to other stockholders. For example, if the investors had put in $25M and owned 50% and the exit was for $30M, the investors would get $25M and the last $5M would be split between founders and employees.
A 1x participating preference is much worse. It means that the investors are paid back first, and then still participate in the payout according to their ownership percentage. In the same example as above ($25M in, $30M exit, 50% ownership), the investors take their $25M back, then the last $5M is split between the founders and employees and investors. Thus, the investors get a full $27.5M and the common stock holders see their payout decrease by another 50% vs a non-participating preference.
- StavrosK 11y agoWhy would the money of the preference not be counted as a payout floor? So, if you and I own a company 50-50, and you have a 1x preference for $25M: * If we exit for $25M, you get all of it. * If we exit for $25-50M, you get 25, I get the remainder, up to 50 (because we're 50-50 and the minimum for you is 25). * If we exit for any more than 50, we split it in half. Does that not make more sense?
- SeoxyS 11y agoRight, that's what a non-participating preference is. The first example I gave. Luckily, that's how most preferences work these days.
- StavrosK 11y agoYour first example made it sound like investors get their money back and that's it for them. In reality, they do participate in the payoff, but only when it exceeds their preference.
- floatrock 11y agoThanks for the clarification, something I'll have to add. Out of curiosity, how does it work across multiple rounds? I implemented 1x participatory preferences as a simple lifo queue... For non-participatory preferences, are there any complications in calculating the "everybody goes equal from here up" point (50 in the above example) when everyone got in at a different round? Can you have some participatory preferences mixed with non-participatory ones? Is there a good reference for that (at least for a typical case)? Or is this a "call your lawyer" thing?
- SeoxyS 11y agoA preference is just a term on the investment. They could be mixed. It can get pretty complicated. Take this scenario: (A) Series A non-participating 5M, (B) Series B non-participating 10M, (C) Series C participating 10M, owns 25%. Founders own 50%, no options pool. Company sells for 30M. - C gets 10M first - B gets 10M next - A gets 5M next - 5M left over, only C is participating; A & B are just floors. - Pro-rata, remaining ownerships ratio of 50:25 = 2:1. - 5M/3*2 = 3.33M goes to founders. - 5M/3*1 = 1.67M goes to Series C investors. Total tallies: - Founder: 3.33M. - Series A: 5M. ROI: 0% - Series B: 10M. ROI: 0% - Series C: 11.67M. ROI: 16% This is mostly for intellectual curiosity, though. If you're a startup founder today… just don't take on any investors who ask for participating preferred. If you're an investor, don't ask for it, it makes you a vulture.