Share and share alike: the cost of participation

by Bradley Hardiman

Recently I wrote a blog post about my dislike of preference shares and how they dis-incentivise founders. The post finished with a request that investors take non-participating preference shares in order to get downside protection to limit losses but without the upside double-dipping of participating preference shares. In a recent deal, I tried to convince another investor to share my philosophy and take non-participating preference shares (I knew that asking him to take ordinary shares was a bridge too far). The response I got was one of considerable resistance. The justification: other investors take participating preference shares, so we should too. To deviate from taking these types of shares would require convincing his investment committee.

Apart from resisting the urge to emulate my mother and say ‘well if other investors put their heads in an oven, would you do it too?’ I got to thinking about why some investors absolutely insist on taking these types of shares. Does it really make a difference to the performance of an investment (even if the founders manage to overcome the dis-incentivising effects)? Another justification I hear: at high exit values (which we all strive for) the effect of participation becomes so marginal to the founders’ proceeds that it makes no difference. My gut tells me that in this situation, if it makes no difference to the founders then it will make even less difference to the investors.

Is getting a marginally better return on an otherwise catastrophic investment worth taking potential serial entrepreneurs out of the industry?

Seeking the truth

I crunched some numbers using a theoretical investment example. I worked out the returns on investment, along with corresponding proceeds to the founders, at different exit values, depending on whether the investors took ordinary shares, non-participating preference shares or participating preference shares. The results surprised me. They might surprise you too.

For those of you who have a deep interest in the sums that are involved in these kinds of calculations, you can download this document. I warn you, it’s quite heavy on the maths, and not for the faint-hearted.

The trends and observations were as follows:

Very quickly, as the exit value increases, the returns to investors who hold non-participating shares starts to track those for ordinary shares. This is not surprising given that non-participating preference shares are designed to protect your investment during the bad times but then share equally during the good times.

While on the subject of downside protection, the figures show that the worst case scenario of selling the company for only 10% of the post money value, the difference between having a preference (of any kind) and not having any preference (i.e. having ordinary shares), means that the investors lose 87% of their investment, as opposed to 90%. Maybe it’s just me, but this difference is marginal, even more so when you consider that any fund will make multiple investments and so will have little, if any, impact on the overall performance of the fund.

Unless of course all of your investments are losing 90% of their value. In which case you have more to worry about than whether you have preference shares. However the difference for the founders in receiving something as opposed to nothing is huge.

As an industry we need to persuade more and more entrepreneurs to do early stage company formation, again and again. I can’t think of anything more dis-incentivising than getting nothing back from so much hard work. Is getting a marginally better return on an otherwise catastrophic investment worth taking potential serial entrepreneurs out of the industry?

The surprising element of the number crunching came from what happened as the investment became more and more successful and the exit value became higher and higher. Once the exit value had passed a certain threshold (the post-money value), the absolute value of the increase in returns from having participating prefs as opposed to other share classes  was the same, regardless of exit value.

At first this seemed counterintuitive. How can the value of this increase be the same when the company is sold for £30 million as when is sold for £100 million? However, when you consider that the benefit of having participating prefs is always a function of the amount invested (remember you get your money back and then you share the rest) it makes a bit more sense. When you actually realise that this increase is in fact the same percentage of the amount invested as the percentage of the company held by the founders, it starts to make sense. Due to the fact that the absolute value of the increase in returns that the investors get is constant, no matter what the exit value is, the marginal benefit of this increase actually becomes lower, the higher the exit value.

In an effort to ensure that this observation wasn’t just a one off, I ran some more scenarios along various themes. These scenarios can be found here.

The results came out the same. While the actual figures were dependant on the amount invested and the relative percentage ownerships, the increase in returns due to having participating prefs was always the same in absolute value, regardless of the exit value. This increase was always the same percentage of the amount invested as the percentage of the company held by the founders.

This realisation was an epiphany, for me at least. At the risk of repeating myself, I will repeat myself.

  • The absolute value of the increase in returns on investment by having participating preference shares (as opposed to non-participating) is the same, regardless of exit value.
  • This increase was the same percentage of the investment amount as the percentage of the company held by the founders.
  • The impact of this increase in returns becomes lower as the exit value of the company increases.

The critical thing here is when there isn’t such a good exit. When this happens, the increase in returns by having participating preference shares equates to a corresponding penalty in the proceeds received by the founders. At lower exit values this penalty is more acute and more likely to cause resentment of the investors by the founders. The exit values that are unlikely to cause such resentment (remember the other justification) are probably the same exit values that make no difference to the investors. As investors, we all strive for very successful exits, where the effects of having participating preference shares ceases to make a real difference to the returns on investment. By having a situation where you benefit more from less successful exits than you do from successful ones, you are investing for failure. Nobody wants to be doing that, do they?

We are seeing more and more investors willing to take non-participating preference shares (and some even taking ordinary shares). While I am not saying we will not work with those investors who insist on taking harsher terms, it stands to reason that we will prefer to work with those who accept more reasonable ones. By creating a level playing field where everybody is incentivised to drive the company forward, these reasonable investors will get access to the best deals with management who will work harder and deliver greater returns. This can only be a good thing, right?