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Jason Lemkin

Participating Preferred I think is somewhat like leasing a car. There's nothing wrong with leasing a car and it has some benefits but leasing can really be a bad deal for the ignorant. Participating preferred allows VCs to give founders a valuation that appears higher than it in fact is - kind of like the low monthly payment on a car lease vs. a purchase. Like leasing, it can leave a bitter taste in your mouth at the end of the deal; in one case, a merger/sale where the investors take home a lot more per share that the founders, the other where large fees and per mile charges upset the lessee when he turns in the car. But if you are sophisticated, participating preferred can be a way for founders and VCs to split the difference on an issue of how fast / how successful a company will be. If the founders sell for a higher price than the preferences clear at (assuming there is a cap) then perhaps they got a slightly better valuation that otherwise. But in my experience, like leasing a car, most people and most times people will come out better sticking to the straight and simple deal.

Paul Lisiak

I agree that the effect of the "participation" is not readily understood by many entrepreneurs. More to your point (and great analogy on the car leasing model), it is definitely not something many quality mid-level job seekers would be sophisticated enough to factor into the expected value calculation of their stock option grant. In my experience on the East Coast, many non-CxO level employees do not even understand the concept of preference.

Participation is simply a "trick of the trade" and is a moving part in a complex negotiation. I do not agree that it is necessarily all bad for companies as it allows VCs to give (if used as intended) more upside potential in the form of a higher pre-money. That said, it should send a signal to an entrepreneur that the VC is "hedging" the downside risk of the investment and is not swinging for the fences on the deal.

I recently received a participation term in trade for a higher valuation under a recap situation. I accepted it as the chance for a big win was far outweighed by the prospect of small win/asset sale. The higher valuation also helped to not completely wash out the existing common that contained my (recently converted) old preferred shares.

Any thoughts on a senior management carve-out pools? This "trick" lessens the effect of participation as it pays certain (decision making) members of the team a fixed percentage of an acquisition pari passu with the participating preferred. I believe the deal is somewhat backhanded to the other employees (who are made even more subordinate), but is sometimes necessary to get critical persons on board with the deal. I guess no deal will ever be completely fair to everyone....

(As a side note, I strongly believe CEOs should generally do a better job explaining all aspects of a VC deal to their employees in order for the economics to be more transparent.)

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When it comes to investing, many first time investors want to jump right in with both feet. Unfortunately, very few of those investors are successful. Investing in anything requires some degree of skill. It is important to remember that few investments are a sure thing – there is the risk of losing your money!


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