This is a guest post by Ivan Hoo, Co-Founder of Inverse.
In most crowdfunding campaigns, ‘deal negotiation’ tends to focus on share price, valuation, and the % of equity to give away; this is fine for most cases if the investors are just getting ordinary shares. But there are many ways to cut a cake.
Here we will look at the impact of options/warrants/convertible on the ROI (return of investment). Then, we will study the preference shares which some institutional investors will only ever invest in and why some are designed for downside protection but some will disadvantage other shareholders to the point that their equity ownership % do not represent the ‘true value’ of their holding. And finally, I will show you how we can model out the exit scenarios, and calculate the value of each share type at various exit values. This modelling is crucial for the management team and the investors to understand the actual value of each share class.
Options, Warrants, Convertible debts
First, in a company structure, potentially, there are options pools, granted options, warrants or convertible debts. These will dilute the equity shareholders in a liquidation event.
See cap table 1 & 2: the outcome of the fund’s distribution varies when there are additional options. In this example, the company has two founders (A and B) and an investor C and is sold for £1m.
In both examples, founders and investor C hold the same number of shares, but the addition of ten options means that all of their ownership in % is diluted. So when the company is sold, each shareholder will get less money, in this instance, a 9% reduction in the exit payout.
Fortunately, all crowdfunding platforms require companies to disclose and include them in the share price calculation, so investors know the equity ownership % in a fully diluted position.
With the dilution effect, some founders wonder if they should put in place options schemes. While it does dilute shareholders, the options scheme is a great incentive to attract and retain employees, many of whom join startups below the market rate. It is fairly typical for companies to have a 10% options pool set up ahead of the round and is seen favourably by investors.
Preference shares
Some campaigns come with preference shareholders. These are usually HNWs or institutional investors who have negotiated a deal with the company. Occasionally, they are also offered to the crowd, but more often than not, crowds do not have access to this share type.
Preference shares are shares that have preferential rights over ordinary shareholders (which is what most crowd investors would get). These preference shares can come with any special rights.
To keep things simple, I’ll only explain the more common preference shares found on the platform.
On the platform, you will see terms such as 1x participating preference shares, 1x non-participating preference shares. Much less common but possible are 1.5x or 2x preference shares, participating or not.
These are downside protection designed to protect the investors’ investment if the company does not perform as well as they hoped. Hopefully, when you finish reading this, you’ll agree that the participating preference shares do more than just downside protection!
1x participating preference shares means that the investor will get 1x their capital back in a liquidation event. And suppose there are any funds left over; in that case, they will be distributed among all the preferred and ordinary shareholders pro-rata based on their shareholding, with an equal claim (‘pari-passu’).
1x non-participating preference shares are more friendly. In this instance, the preferred shareholder will only get their 1x capital back in a liquidation event and won’t participate in the surplus funds. However, it usually has a convertible clause whereby the shareholder can choose to convert their preferred shares into ordinary shares.
Here are some helpful references if you want to understand all the different rights attached to preference shares:
Waterfall
If you find yourself in a situation of discussing preference shares, and perhaps you have different classes of shares and each with their own rights, it’ll be helpful to model this out and present them visually on a graph and a table. Armed with the knowledge of the dynamic of share classes, you can negotiate more effectively and communicate with complete transparency with all investors.
Taking the same scenario as above, now look at cap table 3. Having invested £500k in 1x participating preference shares, Investor C gets the first dip and takes £500k (i.e. his 1x capital) from the £1m. That leaves everyone with £500k for distribution at pro-rata to their shareholdings. The outcome of this is that he gets £700k in total, while the two founders get £150k each.
In cap table 4, investor C holds 1x non-participating preference shares. In this example, he still gets the first dip and takes £500k (i.e. his 1x capital) from the £1m, but he won’t be able to participate in the distribution of the leftover funds. That means both founders will split the £500k equally because they are entitled to 50% each when Investor C is removed from the equation). The outcome of this capital structure serves the founders better than in the above example (Cap table 3), but it is still worse off than if all of them hold ordinary shares (cap table 1).
The three examples we have seen, to recap, ranked from best to the worst scenario for the founders.
- All ordinary shares
- Investor C holds 1x non-participating preference shares
- Investor C holds 1x participating preference shares
Clearly, the capital structure favours the investors in scenario 2 and 3. But what happens if the liquidation occurs at a much higher value?
At this point, a data table (excel function) and a chart are handy to model this out.
Chart 1: investor C gets everything, and founders get nothing in any liquidation value less than £500k. After that, they all participate in the distribution of the funds, pari-passu and pro-rata. Compare this to the red dotted line, which indicates the payout to Investor C if he holds ordinary shares; it’s clear that even at the same valuation, share price and % of ownership, investor C gets more for his money in any liquidation scenarios.
Chart 2: investor C gets everything, and founders get nothing in any liquidation value less than £500k. But after that, investor C doesn’t get to participate in the rest of the pot. As you can see, the founders get more money, faster than the scenario in Chart 1. But compared to owning ordinary shares, it’s clear that investor C is missing the action if the exit did well!
Chart 3: In reality, non-participating preference shares come with the convertible right, which will allow the investor to convert their shares to ordinary shares. So if the liquidation value happens above £1.3m, investor C will convert their shares to ordinary shares and participate in the upside pro rata to his shareholding.
Data table 1 and 2 are computed using excel’s function (Data Table or shortcut key ALT + W + T)
Conclusion
Preference shares obviously give investors better value for their investment, or in the non-participating scenario, they get 1x capital back if the exit value is less than the target. However, it also serves another purpose. By ensuring that founders only reap the rewards when the company hits a certain performance level, the capital structure incentivises the management team/founders to grow the business and aim for a higher exit value.
Non-participating preference shares can be acceptable for downside protection, but, participating preference shares simply gives the investor a better in all exit scenarios. By getting paid twice, the investor gets her cake and eats it too.
Disclaimer: Nothing in this article constitutes legal advice. Specialist legal advice should be taken concerning specific circumstances.
