Start-ups in the Life Sciences field are frequently financed through a combination of equity securities with different rights to its holders. There are several economic rationales behind preferred rights for large investors. Whereas certain (e.g. non-participating) preferential rights serve primarily as a protection of the preferred shareholder’s investments in liquidation- or distressed exit cases, other preferred rights are a non-transparent way to increase the return of the preferred shareholders in all exit cases, at the cost of the common shareholders. In our view as Mergers & Acquisitions (M&A) advisors, it is essential to understand the effects of such rights in an M&A or financing transaction.
Hoffmann & Partner have analysed the use of preferred rights amongst life sciences start-ups in Switzerland in the last few years. The data and information we use in our newsletters are all based on public sources. We did not use transaction data known to us due to our own M&A and advisory activities. In the newsletter of this month, we start the publication of our results with some basics about preferential rights.
This first part focuses on the different types of preferred shares, which are often used in financing structures.
Preferred shares are hybrid securities with characteristics of equity and debt, which are mainly issued to venture capitalist (VC) investors. Preferred shareholders may benefit from additional features compared to common shareholders. For example, preferred shareholders receive fixed dividends as a percentage of the invested face value (comparable to interest payments for a bond). The dividend can be cumulative, which means that the issuer, i.e. the start-up, can defer the payment. Furthermore, preferred shares usually have an advantage over common shares when it comes to a company sale or similar event (M&A transactions). This advantage, called a liquidation preference, means that the preferred shareholder receives benefits from the exit proceeds before the common shareholder. In the case of different preferred shareholders classes, the last in first out principal is applied.
As part of a financing round, the issuer and the investing preferred shareholder need to agree on the form of liquidation preference to be applied in the event of a company sale or similar event. The potential distribution of the funds is illustrated in a so-called waterfall graph (see example 1, 2 and 3).
The two main types of liquidation preferences are participating and non-participating. Participating preferred shares can be further divided into fully participating or participating with cap.
Preferred shareholders receive their liquidation preference (e.g. 1x initial investment and accrued dividends) back. Thereafter, the remaining proceeds are distributed pro-rata among preferred shareholders and common shareholders. In other words, the preferred shareholders can benefit twice, also called double-dip. Example 1 in the graph below shows the exit proceeds for a preferred shareholder with a liquidation preference of CHF 50m. The effect of a 1x (or even worse a >1x) liquidation preference is a simple increase of the return on investment for the preferred shareholder in all exit cases (no matter whether a low distressed / liquidation exit event or a successful billion transaction to a large pharma company)!
Participating with cap
The cap limits the return of the preferred shareholder. For example, a cap at two times (2x) of the invested capital means that the investor receives first his investment back and thereafter participates pro-rata in the proceeds until the cap is reached. Hence, in this example he can earn maximum two times his initial investment. However, the preferred shareholder has the possibility to convert his shares to common shares. Whenever his proceeds from the converted shares are higher than the cap, he converts. Example 2 below shows that with an exit value of CHF 160m and above the preferred shareholder is better off converting his shares into common shares.
With a non-participating liquidation preference, the preferred shareholder has to choose between either his liquidation preference (e.g. 1x initial investment + dividends) or the amount he would receive if he converts the preferred shares to common shares. He is not entitled to both, as it would be the case with fully participating. Example 3 below shows that the common shareholders are able to catch up with the preferred shareholders in the “zone of indifference”. When the exit value exceeds the zone, preferred shareholders would convert.
The economic effect of such preferential rights is only to protect the preferred shareholders in cases of distressed / liquidation exits. In “good” exit cases, such a preferred right has no effect on the distribution of profits between preferred and common shareholders (in our example all exit values > 100 million CHF).
The topic preferred shares is highly relevant in the corporate finance and M&A field, especially for financing rounds of Life Sciences companies and other start-ups. The choice of preferential rights has great impact on the distribution of proceeds, depending on the exit scenarios. In many cases, it may therefore be advisable for founders even to accept lower pre-money valuations in financing rounds, if this allows to keep preferred rights of large investors at a low(er) level.
For our empirical evidence on preferred rights used in life science financing in Switzerland, see our next M&A newsletter.
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