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During a funding round, the price per share paid by investors exceeds the price you paid when setting up your company. This situation justifies the existence of preferred return clauses when selling your company. It is generally hard to go against these clauses, but it is essential to understand the logic behind them to negotiate them well.

What is all this about?

In the event of sale of your company, the preferred return clauses on the sale price enable some of your investors to receive, in some cases, part of the sale price before other investors or yourself. In such cases, the distribution of the sale price will not be proportional to the capital ownership, as investors may receive a portion of the sale price in excess of the proportion of shares they hold.

Why?

These clauses were created through practice in order to correct an issue that is inherent to venture capital and related to discrepancies in cost existing in particular between the founders, who purchased shares at their nominal value, and the various investors, who purchases shares at a higher price.

This difference in cost leads to:

  • Unfair distribution of risk between partners; and
  • Different return expectancy between partners.

A misalignment of interest thus comes to light between the partners, and they are the very people who will have to come to an agreement to reach an exit strategy.

Let’s take the example of fictional company Growth, whose capital is distributed as follows:
Share % of ownership Total cost
Founders 30,000 30% €30,000
Investors 70,000 70% €350,000

If a sale of 100% of the capital were to take place without implementation of any preferred return mechanism, the sale price will be distributed as follows:

Sale price (100%)   €300,000  €500,000    700 000 €
  Price distribution Price % Profit/Loss Price distribution Price % Profit/Loss Price distribution Price % Profit/Loss
Founders €90,000 30% €60,000 €150,000 30% €120,000 €210,000 30% €180,000
Investors €210,000 70% – €140,000 €350,000 70% €0 €490,000 70% €140,000
  • Price distribution is always proportional to share ownership
  • Where the sale price is below €500,000, investors will observe a loss, while founders will have a profit
  • Where the sale price is €700,000, the founders and investors will receive a profit, but the latter will only see an investment multiple of 1.4, while the former will see an investment multiple of 7.

There is a clear misalignment of interest, which can lead founders to wish for a premature exit, or at a price deemed insufficient by the investors.

How can we solve the misalignment of interests between partners?

To solve this misalignment of interests, it is possible to resort to a preferred return clause on the sale price, to the benefit of investors. There are two main categories:

  • Non-participating clause; and
  • Participating clause.

This is the order in which the sale price will be distributed according to both types of preferred return:

First item: each shareholder will recover the nominal value of their shares; then

Second idem: investors will recover the total amount invested by them, less the nominal value already received; and

Third item:

  • Where a non-participating clause is used: the remainder of the price after payment of the first and second items is distributed pro rata between the founders exclusively; or
  • Where a participating clause is used: the remainder of the price after payment of the first and second items is distributed pro rata between all shareholders (founders and investors).

Regardless, the investors, who benefit from the preferred return clause, can give up the application of such clause and opt instead for pro rata distribution exclusively. Thus, in practice non-participating clauses only come into play when the average price of a share sold is below the cost to investors.

What are the effects of these preferred return clauses?

1. Non-participating clauses

With non-participating clauses, correction of misalignment is minimal, only enabling investors to recover their initial investment as priority. Beyond a certain sale price, price distribution is proportionate to capital.

Thus, with a non-participating clause, the allocation of sale price between founders and investors would be as follows:

  • With a sale price of €300,000, investors receive 90% of the sale price in order to neutralise capital losses as far as possible.
  • Up to €500,000, the price distribution is not proportional to capital ownership.
  • From a sale price of €500,000 upwards, sale price distribution is strictly proportional to capital ownership. Founders catch up to investors.

2. Participating clauses

Participating clauses are more favourable to investors in that, as well as having priority that protects them in the event of a low sale price, they will receive an amount proportionate to their capital on higher sale prices.

Thus, in the event of a participating clause, the distribution would be as follows:

  • The profitability threshold of investors is the same as for the non-participating clause (€380,000).
  • Investors receive the majority of the sale price. As well as recovering their initial investment, investors receive, on the remainder of the sale price after distribution of the preference, an amount that corresponds to their share in the capital. Unlike with the non-participating clause, the founders will not be able to catch up to investors.

3. Variations

It is possible to make changes to these clauses in favour of the founders or the investors.

Changes in favour of the founders: instead of refunding the nominal value, it is possible to provide that founders and investors will receive, under the first item (i.e. before payment of the preference) for each share sold, a same proportion of the sale price (generally 5 or 10%). This type of change is increasingly frequent.

Changes in favour of the investors, regarding the multiple: this is a change impacting the non-participating clause, which enables investors to receive under the second item not only their investment minus the nominal value of their shares received under item 1, but a multiple of their investment. This may seem highly favourable to investors, but is only justified if the initial valuation was considered as speculative.

From the simplest to the most advantageous formula for investors, preferred return clauses on a sale price make it possible to align the interests of a start-up’s shareholders with a view to their exit. It is therefore a topic warranting particular attention: the founders have a certain interest in accepting the principle to reassure investors, but they must be careful during negotiation because drafting these clauses is often a complex endeavour.