Contingent Payout Functions for Firms with

Capped Participating Preferred Stock

Jonathan Kaufman
July 11, 2012
Abstract
Participating preferred stock, currently the most common security
choice for venture capital investing, is typically capped to some multi-
ple of its liquidation preference. Capping participation rights complicates
payout functions when multiple securities are involved. Presented here is
a general solution for payout functions for a rm having multiple classes
of capped participating preferred stock. The solution involves the use of
rm-recursion to determine the order in which the rms securities cap
and convert, followed by the consequential distribution of incremental
proceeds to the various securities.
1 Introduction
Venture capital security liquidation involves solving for the the payout of each
security as a function of aggregate payout to all securities of a rm. The primary
constraint is that the sum of all payout functions must equal the aggregate
payout, which we can symbolically represent as follows
v =

i
p(s
i
, v) (1)
where v is the aggregate payout, p is the payout function, and s
i
is the i
th
security.
It is often the case that security (or rm) liquidation involves contingent
payments. The most common example is when a rm is acquired in consider-
ation for a up-front payment and a combination of future payments contingent
on the achievement of milestones. In such case, the aggregate payout, v, is not
known at the time of acquisition. The usual solution is to structure the con-
tingent payments to the shareholders such that the aggregate payments to the
shareholders at any time comply with what the payout to all shareholders would
be as if the complete consideration is the aggregate acquisition consideration at
such time. The determination of such contingent payments to shareholders,
or estimation thereof, is synonymous with the solution of the payout functions
1
p(s
i
, v). This paper provides a method for deriving payout functions for the
most common venture capital investment instrument, capped participating pre-
ferred stock. First, a general solution for payout functions of non-participating
preferred stock is examined. This solution is then generalized to include eects
associated with capped participation rights
2 Non-Participating Preferred Stock
Consider, as a simple example, a company with two securities: preferred stock,
s
1
, and common stock, s
2
, where s
1
has a liquidity preference of $1 per share.
Suppose the rm has issued 50 shares of s
1
and 50 shares of s
2
, and that each
share of s
1
is convertible into one share of s
2
at the holders option. This
circumstance has the following solution set.
p(s
1
, v) =
_

_
v if v 50
50 if 50 < v < 100
v/2 if v 100
, (2)
p(s
2
, v) =
_

_
0 if v 50
v 50 if 50 < v < 100
v/2 if v 100
(3)
It will be convenient, especially as the number of securities increases, to use
the following, more concise notation,
p(v) =
_
p(s
1
, v) p(s
2
, v)
_
=
_
_
v 0
50 v 50
v/2 v/2
_
_
_

_
if v 50
if 50 < v < 100
if v 100
(4)
where columns of function denitions correspond to securities in order of de-
creasing seniority from left to right.
Notice that the solution to this simple scenario has three zones: 1) below
the liquidation preference of the rm, 2) above the liquidation preference but
within the liquidation cap of the preferred security, and 3) above full conversion
of preferred security. Also notice that in each of these three zones, the sum
of p(s
1
, v) and p(s
2
, v) is v, which should always be the case. A graphical
representation of this solution is as follows.
We could generalize this case by naming the liquidity preference of s
1
as
1
and the proportional ownership of s
1
, on an as-converted basis, as
1
. This
more general solution is
p(v) =
_
_
v 0

1
v
1
v
1
v(1
1
)
_
_
_

_
if v
1
if
1
< v <
1
/
1
if v
1
/
1
(5)
2
150 0 50 100
150
0
50
100
v
p
(
v
)
s1
s2
conversion
liquidation preference
Suppose the rm has three securities, instead of two, and that the new
security is a preferred stock which subordinates the rst two securities. It will
be helpful to name (or rename as the case may be) the three securities in order
of decreasing seniority (i.e. s
1
, s
2
, and s
3
represent the new preferred stock, the
original preferred stock, and common stock respectively). Solving for the payout
functions of this slightly more complex situation is not a simple extension of the
solution above, because we do not know a priori the order with which the two
preferred stock securities would convert into common.
The possible permutations of conversion sequence are (s
1
, s
2
) and (s
2
, s
1
).
Before stating the general solution set corresponding to each of these two pos-
sible permutation sequences, we must rst consider a notation for proportional
ownership of a security, on an as-converted basis, that takes into account the
possibility of a varying set of security conversions. The number of shares of the
rm, on an as-converted basis, depends upon which (if any) of the convertible
securities have converted in any given payout zone. Consider the notation
1
1,2
to represent the fraction of shares of security s
1
(both on an as-converted basis)
when securities s
1
and s
2
constitute the securities that have converted to com-
mon (or are common). Also consider the following construct which similarly
represents the fractional ownership of security sets.

1,2
1,2,3
=
1
1,2,3
+
2
1,2,3
Similarly, it will be useful to use the following shorthand for stacked liquidation
preferences.

1,3
=
1
+
3
(6)

1...n
=
n

i=1

i
(7)
Using this notation, the two possible solutions for the above three-security
3
example are
p
(s1,s2)
(v) =
_
_
_
_
_
_
v 0 0

1
v
1
0

1

2
v
1,2
(v
2
)
1
1,3

2
(v
2
)(1
1
1,3
)
v
1
1,2,3
v
2
1,2,3
v(1
1,2
1,2,3
)
_
_
_
_
_
_
_

_
if v
1
if
1
< v
1,2
if
1,2
< v
2
+
1
/
1
1,3
if
2
+
1
/
1
1,3
< v
2
/
2
1,2,3
if v
2
/
2
1,2,3
(8)
p
(s2,s1)
(v) =
_
_
_
_
_
_
v 0 0

1
v
1
0

1

2
v
1,2

1
(v
1
)
2
2,3
(v
1
)(1
2
2,3
)
v
1
1,2,3
v
2
1,2,3
v(1
1,2
1,2,3
)
_
_
_
_
_
_
_

_
if v
1
if
1
< v <
1,2
if
1,2
< v
1
+
2
/
2
2,3
if
1
+
2
/
2
2,3
< v
1
/
1
1,2,3
if v
1
/
1
1,2,3
(9)
These two possible solutions correspond, respectively, to the two conversion
sequence permutations: (s
1
, s
2
) and (s
2
, s
1
).
This general solution for a rm with three securities (two convertible-preferred
and one common) has ve payout zones. The rst two payout zones simply cor-
respond to satisfying the liquidity preferences of the preferred securities prior
to distributions to any subordinate securities. The two preferred securities are
paid in order of decreasing seniority. Thus zone 1 involves the distribution to s
1
exclusively, and zone 2 involves the distribution to s
2
exclusively. This exam-
ple assumes that s
2
is subordinated by s
1
, which is consistent with the naming
convention of ordering securities subscript numbers by subordination. If alter-
natively the two securities were designed to receive proceeds pari passu, then
these two zones would be combined into one. The rst two zones end when the
aggregate payout is
1,2
, which is the total liquidity preference obligation of the
rm.
Zone 3 involves the catch up of common stock distributions prior to the
rst conversion of the preferred securities. Zone 4 is the range where one of the
two convertible preferred securities has converted. The formulas are constructed
such that the residual (i.e. aggregate payout less remaining liquidity preference)
is proportionally distributed among the converted securities. Zone 5 is the point
above which all convertible securities have converted.
To determine which of the two possible solutions is applicable for a given
situation, we can compare their initial conversion points

2
+
1
/
1
1,3
vs.
1
+
2
/
2
2,3
(10)
which correspond to
(s
1
, s
2
) vs. (s
2
, s
1
) (11)
The operable permutation is thus
(s
1
, s
2
) if
2
+
1
/
1
1,3
<
1
+
2
/
2
2,3
(12)
4
and vice versa. In the event that
2
+
1
/
1
1,3
=
1
+
2
/
2
2,3
, both s
1
and s
2
would convert at the same point.
This method of analysis can be extended to include additional convertible
preferred securities. However, notice that the number of permutations of con-
version sequences of n preferred securities is n! (n factorial). So the complexity
will increase rapidly. When generalizing this treatment to accommodate addi-
tional securities, it is rst necessary to determine the zones (by determining the
sequence of security conversion). This can be accomplished by working back-
wards from full conversion (i.e. the highest price event). Consider a rm with
a total of four securities: three levels of convertible preferred stock s
1
, s
2
, s
3
,
and common stock s
4
. The price at which the last of s
1
, s
2
, s
3
converts is
v = max(
1
/
1
1,2,3
,
2
/
2
1,2,3
,
3
/
3
1,2,3
) (13)
We can generalize for n preferred securities, and in such case, the price at which
the last preferred security converts is.
v = max(
1
/
1
1...n
, . . .,
n
/
n
1...n
) (14)
In the case of the four-security rm, the price at which the second-to-last of the
two remaining securities (s
x
, and s
y
), assuming s
z
will not have converted, to
convert is
v = max(
x
+
y
/
x
y,z
,
y
+
x
/
y
x,z
) (15)
where
z
is the liquidity preference associated with the last security to convert.
Determining the conversion sequence is like peeling o layers of an onion.
In this analogy, the whole onion represents the rm, and the outside layer of
the onion is associated with the last liquidity preference to survive. Removal of
the outside layer yields what would be analogous to a hypothetical rm that is
the same as the original rm except that it would not have issued the security
associated with the outer layer of the original and the rms payout would
be reduced by the associated liquidity preference. Deeper layers correspond
to hypothetical rms that are the same as the rm associated with the layer
distally adjacent except for the loss of the associated security and its associated
liquidity preference.
To formalize this we need a notation for an initial rm as well as the medially
adjacent sub-rm (i.e. the hypothetical rm without the security which was
the last security to convert). We can denote the original rm as
m
and the
medially adjacent sub-rm as
m1
, where
m
has m securities and
m1
has
m1 securities. Keep in mind that is a composite variable that is specic to
a state of a rm corresponding to the rms historical transactions as well as its
securities.
Consider a function, f, that transforms
m
into
m1
,

m1
= f(
m
) (16)
as well as a function, g, that returns the last security to convert when given a
5
rm as a parameter.
s
m
= g(
m
) (17)
In the equation above, we use a notation in which the superscript is indicative
of the securitys placement in the sequence with which the all securities of the
rm
m
convert. This is not to be confused with the prior subscript notation
(i.e. s
n
), which is indicative of the securitys placement in decreasing order of
liquidation seniority.
As described above, s
m
can be determined by (and thus g can be dened
by) considering the necessary condition.

m
/
m
1...n
= max(
1
/
1
1...n
, . . .,
n
/
n
1...n
) (18)
Furthermore, s
m1
can be determined by,
s
m1
= g(f(
m
)) (19)
and likewise,
s
m2
= g(f(f(
m
))) (20)
and so on. This recursion continues until the conversion sequence of all convert-
ible securities is determined.
Having an algorithm for determining the sequence with which the securities
of rm will convert, the payout to any given security can be described. The
complex region of the payout functions is within the range beginning at the
satisfaction of the rms complete aggregate liquidity preference and ending with
the last security conversion.

1...n
< v <
m
/
m
1...n
Assuming the following notation for a set of converted and un-converted secu-
rities to be and respectively, the payout to security s
q
is as follows.
p(s
q
, v) = (v

)
q

(21)
The determination of which securities are in or is determined by identifying
where v occurs in the conversion sequence.
3 Participating Preferred Stock
As its name implies, participating preferred stock does not need to convert
to common to receive proceeds after the rms aggregate liquidity preference
has been satised. It participates with common without requiring conversion,
though most issuances of participating preferred stock do have participation
caps. The cap is usually a whole-number multiple of the securitys liquidity
preference. Securities with participation caps must convert to common to to
participate beyond the cap.
6
Consider a simple example using participating preferred stock. As in the
original example, consider a rm with two securities: s
1
participating preferred
stock, and s
2
common stock. Also suppose that the rm issues 50 shares of each
of the two securities, and that s
1
has a liquidation preference of $1 per share,
but now has a participation cap of $2 per share. The pay-out diagram for this
rm is as follows. Notice the four payout zones: 1) liquidation preferences,
300 0 50 100 150 200 250
150
0
50
100
v
p
(
v
)
s1
s2
conversion
liquidation preference
participation cap
2) participation, 3) cap (or catch-up), and 4) full conversion. The general
solution to this scenario is as follows.
p(v) =
_
_
_
_
v 0
v/2 + 25 v/2 25
100 (v 100)
v/2 v/2
_
_
_
_
_

_
if v 50
if 50 < v < 150
if 150 < v < 200
if v 200
(22)
The capped participation rights shift the full-conversion aggregate payout re-
quirement from $100 out to $200. The general solution to this scenario (where

1
is the participation cap of s
1
) is as follows.
p(v) =
_
_
_
_
v 0

1
+ (v
1
)/
1
1,2
(v
1
)/(1
1
1,2
)

1
v
1
v/2 v/2
_
_
_
_
_

_
if v
1
if
1
< v <
1
+ (
1

1
)/
2
1,2
if
1
+ (
1

1
)/
2
1,2
< v <
1
/
1
1,2
if v
1
/
1
1,2
(23)
The simple examples of single-preferred security scenarios including partic-
ipating and non-participating preferred demonstrate that capped participation
rights can provide a signicant benet to the preferred security holder, but not
to the extreme of the liquidation preference multiples that were popular in the
late 90s. A graphical comparison for our examples is as follows. The magnitude
of benet associated with the two kinds of liquidation preference rights varies
7
300 0 50 100 150 200 250
150
0
50
100
v
p
(
v
)
1X liq. pref.
2X partic. cap
2X liq. pref
with the specic nancing conditions of the rm. Notice in the illustration
above that when a preferred security, s
q
, has participation rights, it no longer
converts at
q
/
q

, where represents, as above, the set of converted securities.

The new conversion price becomes
q
/
q

.
As in the case regarding the multiple non-participating preferred securities,
the rst step in determining the payout functions for a rm with multiple partic-
ipating preferred securities is to determine the sequence and prices at which the
securities convert. However the details governing functions f(
m
) and g(
m
)
are dierent. The necessary condition for s
m
becomes dependent on instead
of .

m
/
m
1...n
= max(
1
/
1
1...n
, . . .,
n
/
n
1...n
) (24)
The equation above does not include eects of the liquidity preferences in ad-
dition to the participation caps since it is only concerned with the maximum
conversion and such conversion precludes the possibility of prior liquidity pref-
erences or participation caps not being met, given that participation caps are
always larger than their associated liquidity preferences. A generalization of
the denitions f and g among s
m
,
m
is now required to include the eects of
capped participating preferred securities, which in turn requires a further par-
tition of the payout range to take into account inection points associated with
the participation caps.
The scenario which consisted of two classes of non-participating preferred
stock had two conversion sequence permutations to consider. With participating
preferred the number of possible permutations increase to six, and are as follows.
(s
1cap
, s
1conv
, s
2cap
, s
2conv
) (25)
(s
1cap
, s
2cap
, s
1conv
, s
2conv
) (26)
(s
1cap
, s
2cap
, s
2conv
, s
1conv
) (27)
(s
2cap
, s
2conv
, s
1cap
, s
1conv
) (28)
8
(s
2cap
, s
1cap
, s
2conv
, s
1conv
) (29)
(s
2cap
, s
1cap
, s
1conv
, s
2conv
) (30)
Even though there are four possible events that we can order, the number of
possible permutations is less than 4! because there is the constraint that payment
to a security will always cap prior to conversion. Notice also that the six possible
solutions are in two symmetric groups.
An example for payout functions of a rm having two classes of participat-
ing preferred stock is as follows. This illustration represents the solution to a
450 0 50 100 150 200 250 300 350 400
150
0
50
100
v
p
(
v
)
s2cap
s2conv
s1cap
s1conv
Label
s1
s2
s3
scenario where a rm has issued 20 shares of s
3
, 30 shares of s
2
, 27 shares of
s
1
. The liquidation preferences for the two classes of preferred stock (s
1
and
s
2
) are $40 and $30 respectively, with 3X and 2X participation caps. These
liquidations preferences (considered each to be 1X) correspond to share-prices
of $1.4815/share and $1.000/share respectively.
In the illustration above, the sequence of capping and conversion events of
the two preferred securities is as follows.
(s
2cap
, s
2conv
, s
1cap
, s
1conv
) (31)
The illustration shows inection points at v = $40 and v = $70 which are
associated with the 1X liquidation preferences. Following that s
2
has a 2X cap
at $147 and converts to common at $194. s
1
has a 3X cap at $268 and converts
to common at $342.
Consider the rationale behind the inection sequence.
(s
2cap
, s
2conv
, s
1cap
, s
1conv
) (32)
First consider identifying s
m
. To do so we must identify.
max(
1
/
1
1...3
,
2
/
2
1...3
) = max(
120
0.3506
,
60
0.3896
) = max(342, 154) = 342 (33)
9
Therefore, one of the four inection points is known.
(, , , s
1conv
) (34)
Since a security cannot cap after it converts, we know that the initial inection
point must be either s
1cap
, or s
2cap
. We can calculate what each of the payout
totals would have to be for each of the two securities to cap rst.
v
n.cap
=
1

2
+

n

n
1...3
(35)
These two payout totals for s
1
and s
2
are $298 and $147 respectively. Thus we
now know two of the four inection points.
(s
2cap
, , , s
1conv
) (36)
Knowing these two inection points, we can next identify which of the two
remaining events (s
2conv
and s
1cap
) follows s
2cap
. If the rst of the two events
were to be s
2conv
, the cumulative payout v at such point would be $194.
v =

2

2
1...3
+
1
= 194 (37)
Alternatively, if the rst of the two events were to be s
1cap
, the cumulative
payout v at such point would be $239.
v =

1

1
1,3
+
2
+
1
= 239 (38)
Thus, the second inection point is s
2conv
, and by process of elimination, we
arrive at.
(s
2cap
, s
2conv
, s
1cap
, s
1conv
) (39)
We now know three of the four inection point prices.
(147, 194, , 342) (40)
The fourth is $268,
v =

1

1
1...3
+
1
= 268 (41)
and thus we have the following four inection points.
(147, 194, 268, 342) (42)
Notice that the payouts to the asset classes can no longer be governed by
the prior relationship for the case of non-participating preferred securities, which
was
p(s
q
, v) = (v

)
q

(43)
10
because the relationship does not incorporate the capping eects. A general-
ization is required to distinguish between securities that are in the capped and
non-capped range as well as the converted and non-converted rage. Recall that
and represented the sets of converted and unconverted securities respec-
tively. Now the unconverted set, , must be further split into
c
and
u
, which
represent the sets of capped and uncapped unconverted securities respectively,
resulting in the following generalized payout.
p(s
q
, v) = (v
u

c
)
q
+u
(44)
Note that this formula is only valid for v in the range of uncapped s
q
, since, if
s
q
were capped, p(s
q
, v) would simply be
q
.
4 Discussion
The solutions presented here do not take into account all possible real-world situ-
ations. Common departures from the present analysis include: time-dependence,
cross-security ownership (rational investor decisions), and the existence of ad-
ditional derivative securities such as options and warrants.
Time dependence. In general, the payout function(s), p, can be time-dependent.
This would be the case if, for example, the rms capital structure includes con-
vertible debt with an interest rate or preferred stock with cumulative dividends.
Cross-security ownership The solutions also assume that all holders of secu-
rities act rationally. Any given security holder may (and typically does) hold
multiple classes of securities. All or portions of the outstanding shares of certain
securities may not convert as expected, given that optimizing the payout for a
given security may not produce an optimal payout for a controlling shareholder
of such security.
Additional derivatives Warrants for the purchase of capped participating
preferred stock typically exist in cap tables, especially for rms that have used
bridge nancing between nancing rounds. For the most part, these securities
behave similarly to the securities that they would convert into. (In fact, they
typically behave just like the counterpart securities, except as if such securities
did not have a liquidation preference and as if the participation cap was one
multiple smaller. The reason for these two deviations is that the liquidity pref-
erence of the derivative security is oset by the securitys exercise price, and
that this cashless exercise thus diminishes the eective cap by one unit.)
In general, most any private equity nancing event involves customization
to satisfy particular requirements of stakeholders, and thus a completely gen-
eral solution would be unrealistic. However, a quantitative understanding the
relationships of various factors can confer signicant benet when negotiating
or structuring venture capital investments, and complete solutions for specic
rms are usually required when completing an exit (e.g. acquisition) that in-
volves contingent payments.
11