Participating Preferred Returns and What They Mean for Investors and Start-Ups

Entrepreneurs routinely find that starting their own business is a major challenge in many ways. At the top of that list of challenges is securing enough capital to get the business off the ground. It feels like if you just had a nest egg to build from, your idea or service or product would have room to grow, and that nest egg could be parlayed into the success of your dreams. While the people who are considering whether to give your business the head start that it desperately needs clearly hope to help you, they aren’t sinking money into your business out of the kindness of their hearts. One option they could potentially request as a condition of investment is known as Participating Preferred Stock. Our Managing Partner Paul Skeith explains this option and what it means when investors request Participating Preferred Returns. 

Breaking Down Participating Preferred Stock

This week, I’m talking about the resurgence of investor asks for returns on their Participating Preferred Stocks. 2023 has been a challenging year for companies seeking venture capital investments. According to Crunchbase, Global VC funding totaled $76 billion in the first quarter of 2023, a 53% drop from the first quarter of 2022. As a result of the relative scarcity of dollars being invested, investors are in a much stronger bargaining position than any other time over the past decade. One result of this is that investors are once again asking for Participating Preferred Returns. 

What are Participating Preferred Returns? They are a type of liquidation preference that gives investors the right to receive their initial investment back plus a fixed percentage, usually 8% to 10% per year, before any other shareholders get paid in the event of an exit. In addition, investors also get to participate in the remaining proceeds on a pro-rata basis with the common shareholders. This means that, in effect, investors can potentially double dip and get a larger share of the exit value than the company’s employees, and even its founders. 

A Bear Market Means Investors Have the Upper Hand

Participating Preferred Returns are often criticized as unfavorable for entrepreneurs as they reduce their incentives and dilute their ownership. They were more common during the Dot-Com burst period and the 2008 financial crisis when investors had more bargaining power and startups faced more uncertainty. However, they became less prevalent in the past decade as startups enjoyed a favorable market with high valuations and abundant capital. 

The resurgence of participating preferred returns this year in 2023 reflects a shift in the balance of power once again between investors and entrepreneurs, as well as a sign of caution and risk aversion in the VC market. Investors are looking for more protection and higher returns on their investments, while entrepreneurs have fewer options and less leverage to negotiate. This trend poses a challenge for startups seeking venture capital funding in 2023. 

Don’t Give Away the Farm

New business owners must be careful about being particularly selective and strategic about who they partner with, how much they raise, and what terms they are willing to accept. Their businesses will also have to demonstrate strong traction, revenue growth potential, and even profitability to attract investors who are willing to offer more favorable terms. If you’re an entrepreneur trying to jump-start your start-up, and you need experienced counsel to discuss your investor options, Richards Rodriguez & Skeith’s Business & Transactional team may be able to help! Contact us today to find out how!