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Participation Preferences

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).

Cashing Out

There are quite a few routes to cashing in on your idea or business.  The quickest and easiest is to sell early.  Most larger tech companies have a budget for building their business by acquiring smaller companies.  Depending on the value that you bring to the table, whether that is a technology, talent, community, etc., you may be able to get a quick return if that’s what you are looking for.  By positioning yourself for visibility, you better attract early interest.  This may be by virtue of your website, yours or other blogs, showcase conferences, etc.  Good open source projects also fit here, where companies can acquire you in support of their open source initiatives.  Almost all acquisitions will come with a job, since the talent is almost always an important part of what they are acquiring.

If you’re not acquired early, there are more options for cashing a little out before your final liquidity event.  In each round of serious financing – Series-A, Series-B, Series-C – you may be allowed to sell some shares.  This is negotiated up front and if you’re interested in it you should look for investors that are either in for or will allow a secondary sale.  There are two ways a secondary can take place: (1) you sell your shares direct to buyers in a transaction that takes place just after the financing, or (ii) the company purchases your shares and the resells the to the investors as part of the financing.  If the investment is a second round of funding or later, you may be asked to discount the price on the shares that you sell.  If the transaction is structured as (i), then your shares are somewhat less valuable as they carry no preference, or a lower preference from an earlier round.  If the transaction is structured as (ii), you’ll be asked to discount just the same, since the later round now has a larger pool.  Discounts are usually 10% to 20% – depending on the difference in preference.


Each round of financing carries a preference, in for the amount invested and possibly a multiple on that.  So a 2x preference on a $5MM investment mean that that investor will get the first $10MM out of any liquidity event.  This is true until a later investor gets a preference of a higher priority preference as approved by all the investors including the one with the earlier preference.  These preferences are much of what make preferred shares preferred over common shares.  Employee stock options are convertible into common shares and carry no preference.  Preferences play into the sales price of a company, in that if a 10% investor gave $10MM at a 2x preference, you’ll need to sell the company for $200MM or the preference will eat into the amounts payable to the other owners.

Angel Funding

One of the first questions that comes up in Angel Funding is “how much am I getting” and “how much am I giving away”.  Angel funding is often achieved with a convertible note, which makes answering the second question much easier.  Whatever the amount you get, a convertible note will have an option to convert to equity on a future funding, at a discount.  So for example, if you get $100,000 on a convertible note that offers a 10% discount – and the later round is for $1MM, then after conversion your investor would own 11% based on the discount.  This means that you don’t have to set a value until the later investment when you have more to base that value on.  There will often be a lower bound on the conversion – so that more angel financing would not trigger the conversion and could be brought in under additional convertible notes.  There is sometimes also an upper bound to insure that the investment is not diluted if the first round is much bigger and farther away.  Discounts tend to range from 10% to 20%.  If an investor brings more to the table in terms of contribution to the company, they may also want a direct equity grant.  Som convertible notes carry a preference (1.5x to 2x) insuring that multiple on the investment is the first paid out on a liquidity event.