Participation preferences for investors are often stated in terms of a preference multiple and a participation cap multiple – which are two entirely different things. The preferred investor is first paid their investment at the preference multiple, and then participates with the common shareholders in the remainder of the purchase price (per the percentage interest each has in the company) until the preferred investor is paid a total equal to the original investment time the participation cap (including the amount already paid out).
For example, say A and B own Company X equally (50/50). They then create a 20% ESOP, so they now own 40% each. An investor invests $10MM at a $100MM (pre) valuation, with a 1x preference and a 2x participation cap. The investor now owns 10%, A owns 36%, B owns 36%, and employees account for 18% (assuming options for all ESOP shares are granted and exercised).
If the company sells for $20MM, the preferred investor first gets paid back its $10MM. The remaining $10MM is distributed per ownership, for an additional $1MM to the investor (it owns 10%). The investor takes $11MM, and the original owners and employees share the remaining $9MM. This is much better result for the owners and employees than a 2x preference, where the preferred investor in this example would get the entire $20MM and the owners and employees would get nothing.
If the company is sold for $110MM, the investor first gets paid back its $10MM, and the remaining $100MM is distributed per ownership, for an additional $10MM to the investor. Here the investor has reached its cap. So for prices from $110MM to $200MM, there is no difference in return to this preferred investor since they have reached the cap. This is known as the “Dead Zone.”
At prices over $200MM, the investor would convert to common and share per ownership – yielding somewhere over $20MM depending on the sales price (the investor gets 10% of the sales price).