The formulas, tricks and trade secrets of Private Equity
Short answer, they don’t. No one deserves preference shares;it’s simply another lever attached to the deal. If the vendor wants a higher valuation, then maybe I’ll pull this lever and demand my equity have preferred status. (See The value-based components of a private equity deal for information on the value of preference shares.)
The benefit of preference shares is that it subordinates ordinary equity in the case of a wind up or if at exit the returned cash is less than the cash invested.
Let’s look at an example. I invest $200m for 50% of a business as preferred equity, while management owns the other 50% as ordinary equity. If the exit equity value were $500m, I would receive $250m (all else equal). If the exit equity value were $400m (the same as the entry value), I’d get my $200m returned. However, if the exit equity value were $300m, in which case my equity would be worth $150m if it weren’t preferred, I would actually get my original $200m back due to the preference shares status.
As you can see,this preferred status has real tangible value. No one really deserves this value by default; it is simply negotiated into a deal. Some people will use all sorts of baseless arguments to suggest why they “deserve” preference shares, but it’s all bollocks as far as I’m concerned. So, whether it’s a founder saying they deserve preferred status or other investors saying the same, be sure to understand the real value of this status and simply build it into the deal and your valuation.
The other by-product of preference shares status is the coupon (interest payment) that preferred equity often attracts. See my previous post on coupons (preference shares and convertible notes) to see a similar argument about how coupons affect value.
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