Preferred equity: preference and participation
First claim on the downside, a share of the upside. Where converting beats the preference, and what participation costs the common.
- Decide whether non-participating preferred converts or takes its preference
- Calculate participating preferred's proceeds and what it costs the common
- Find the exit value at which the investor converts
- Explain why a minority investor asks for a preference
The intuition
You lend a friend $100 toward a food truck in return for 40% of whatever it sells for one day, with a promise: if it sells for less than it should, you get your $100 back first. If it sells for a lot, 40% is worth more than $100 and you take that instead. You can choose, and you choose whichever is bigger.
That is non-participating preferred equity with a 1x liquidation preference. A tougher version, participating preferred, does not choose: it takes the $100 back and then 40% of what is left as well. Founders call it double-dipping.
Non-participating = the larger of the preference and ownership × exit. Participating = preference + ownership × (exit − preference). Conversion point = preference ÷ ownership.
Why it works
- The conventions here: one class of preferred held by the investor, convertible into a stated share of the common, and no debt. Participation is uncapped. The founders and management hold the common and get whatever is left.
- The preference is a multiple of the money invested, usually 1x, paid before the common sees anything.
- Below the preference the investor takes the whole exit and the common gets nothing.
- Between the preference and the conversion point, non-participating preferred takes its preference, and the common absorbs the whole shortfall, even though it owns most of the shares.
- Above the conversion point non-participating preferred converts and everyone shares pro rata, as if there were no preference.
- Participation always pays at least as much as non-participating. Once the investor would have converted, the extra it takes is the preference × (1 − ownership), for ever, unless there is a cap.
| Conversion point: 100 ÷ 40% | 250 |
| Exit 80: below the preference | Investor takes all 80; common gets nothing |
| Exit 200: 100 against 40% × 200 = 80 | Takes the preference, 100; common gets 100 for 60% of the shares |
| Exit 400: 100 against 40% × 400 = 160 | Converts, 160; common gets 240 |
| Participating at 400: 100 + 40% × 300 | 220, costing the common 60 |
60 = 100 × (1 − 40%): the participation premium above the conversion point.
The formulas
Paid back first.
The investor's share if it converts.
It chooses.
It takes both.
Where converting matches the preference.
Worked example
Work out the preference and the as-converted share, and take the larger.
See it move
Same investment. Change the investor's ownership, the size of the preference and the exit.
- Raise the exit. The investor's proceeds never fall: everything up to the preference, then the preference, then its converted share.
- Raise the ownership. The conversion point falls: converting pays sooner.
- Raise the preference. The conversion point rises, and the common absorbs the shortfall over a wider range of exits.
- Push the exit past the conversion point. The participation premium stops growing and stays at the preference × (1 − ownership).
Run it backwards
Same investment, reversed: above what exit value does the investor convert instead of taking the preference?
Converting pays ownership × exit; the preference pays a fixed amount. They are equal where exit = preference ÷ ownership.
It tells you whether the structure is protection or a price cut. If the sponsor's base case is well above the conversion point, the preference only matters in the downside; if not, the common is giving up value in the expected outcome.
Traps
Say it in the interview
“Explain the difference between participating and non-participating preferred.”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Non-participating = the larger of the preference and ownership × exit.
- Participating = preference + ownership × (exit − preference).
- Conversion point = preference ÷ ownership.
- Below it, the common absorbs the shortfall.