Private Equity: Convertible pref stock

One thing that I don´t clearly understand: it seems as per schweser and cfa texts that “subsequent” rounds of preferred stock will have more seniority compared to the first preferred stock issued I guess they mean that our friendly private equity investors are buying the second one, right, the one with more seniority? If not, does not make sense to me what do you think?

yeah, i found it also weired

i think what they are implying that in order for people to buy in into the second round of preferred stock offering you have to give them incentives, and giving them higher seniority accomplishes that

ok… but who are the buyers of the second round? private equity investors or new “public” investors? that is what I don´t see

it could be PE investors, VC investors, or strategic partners angels and/or VC funds usually provide early stage financing and get the first round of preferred stock, and then the others come into the picture when additional funds are needed

hala_madrid Wrote: ------------------------------------------------------- > ok… but who are the buyers of the second round? > private equity investors or new “public” > investors? that is what I don´t see It cannot be public inventors as the company hasn’t done an IPO yet. If the company needs additional funds pre-IPO, then its called mezzanine investment. Plus remember that the startup will only ask for additional funds if it is running out of cash. At that point, it will have less leverage & later investors can demand better terms for their investments.

The seniority of subsequent rounds doesn’t have much to do with a lack of leverage on the startup’s part. A typical venture-backed startup will plan from the very outset on raising at least a few rounds of private funding. The reason is simple – the earliest money is the highest risk capital and therefore demands very low valuations, imposing substantial dilution on the entrepreneurs. Angel and first-round VC fundings can take 30-40% or even more of a company. As a result, the entrepreneurs typically want to raise just enough money in an early round to get through their next development milestone (which will put them in a position to raise another round at a good “bump up” in valuation), but not much more since the early money is (hopefully) the most expensive capital they’ll ever raise. Assuming the company is meeting its development milestones, subsequent rounds come in at (much) higher valuations. In exchange, later round investors demand many things, including seniority over prior rounds in the event of a sale or liquidation. A start-up can go through several rounds this way, with the securities typically given catchy names like “Series A Preferred”…“Series B Preferred”…and so on… Other than the possibility of initial funding from angel investors, venture capital funds typically provide all of this pre-IPO capital. Sometimes the same fund or funds will finance every round. Other times, different funds will come in to provide the later stages of capital.

thanks for the explanation. but then what is the incentive for the original investor if their investment is diluted so much ?

Because those senior preferred shares will get paid off and converted to common shares (I think). The founders should have the bulk of the common shares, and so they’ll have control over the cash flows once the preferreds are gone.

If things are going well, the increase in valuation more than makes up for the dilution. In other words, your ownership may go from 30% down to 20%, but now the company is valued at $30MM instead of $10MM, so the value of your investment has doubled from $3MM to $6MM. And yes, the preferred shares convert to common in an IPO.