What Is Preferred Stock, and Why Don’t Investors Want Common?
You will face many choices as a budding entrepreneur. You may be prepared to make some of those choices (Where will you work? What will you build?) but others may seem more complicated or difficult to understand.
An important choice you will have to make is the type of corporate entity you choose when forming your company. As you probably know by now, venture capital investors (and most others) prefer to invest in Delaware C-Corporations. There are many reasons for this, most of them tax related. However, investors also like Delaware C-corps because shareholder rights for these entities are very well established, easy to change, and can establish very different rights (or classes of shares) depending on the timing of the investment. Also, Delaware tends to historically be much friendlier to Boards than employees, which benefits investors.
When you formed your company, you probably issued yourself (and your co-founders) a bunch of common stock reflecting your contributions to the company. You hopefully hired an attorney who walked you through the process and put together your cap table, you started your business, and now you’re far enough along that you’re thinking you’re ready to raise some outside funding. You may have even been able to issue some common stock to an angel investor. More likely, you issued them a SAFE, or convertible note, to avoid putting a price tag on your business early. However, once you get to the big leagues, no one is going to want your common stock. Why not?
Preferred shares, generally, do not have the same voting rights as common shares. If every startup had a one hundred percent chance of becoming a public company, we wouldn’t worry about this. If that was the case, your common stock would always ultimately be valuable, and nobody would have to worry about what happens if things go sideways. However, investors can attach many other rights to preferred shares, which make them much more influential than common shares. Fred Wilson, of A (VC) and Union Square Ventures, has a fantastic explanation of the main difference between preferred and common shares. “Preferred stock takes its name from a critical feature of preferred stock called liquidation preference. Liquidation preference means that in a sale (or liquidation) of the company, the preferred stockholders will have the option of taking their cost out or sharing in the proceeds with the founders as common stockholders.” Liquidity events, as they’re known, are the focal point of any investor’s interest in a company. The goal here is not necessarily to benefit when your company does well, but to protect the investment if you fail.
What Fred is essentially saying is that when an investor has a liquidation preference, they already have a baseline idea of what they’ll make regardless of who else invests in the company, or how much each common share ends up being worth. Liquidation preferences can eat up large portions of mediocre exits for companies. Here’s a quick example: You have 1M shares of common stock in your company. You’re doing well, and you raise outside funding from a VC. An investor leads your series A, and gets a $5M liquidation preference, in addition to buying 100,000 shares of preferred stock. Let’s say they invest $6M at a post money valuation of $12M. Yes, you’ve just sold off half your company, but now the investor has their downside covered. They really only have to worry about that extra $1M, and hope for upside. If you exit (sell) for anything more than $5M, the investor will immediately get that back, before your common shares get anything.
Fred goes on, “What this means is that if the value of the sale of the company is below the valuation the preferred investors paid, then they will get their money back. If the sale is for more than the valuation the preferred investors paid, then they will get the percentage of the company they own.” Fred goes on to include other rights investors frequently attach to preferred shares. What other rights can investors attach to preferred shares? Almost anything they want, within the bounds of the law. They can include provisions like Change of Control Rights, that dictate their say in big changes to your company, like new financing, debt, or changes in Board and executive structure and compensation. They can include things like pro rata participation, which gives them the right to buy into the next round your company raises and maintain their position (percentage owned). They could also include things like conversion rights, which would allow their shares to convert to common (in the event you do well) at more than a 1:1 ratio. They will also contain anti-dilution preferences, either weighted average or the much harsher dreaded “full ratchet,” which I’ll save for another post. If an investor just took common shares in your company, they wouldn’t have any of this additional influence or control.
Typically, investors won’t get too aggressive with their preferred share rights. In a market where capital is plentiful, founders benefit. However, in down-turns, investors may think more about how to protect themselves if things go south. In times like this, it’s vitally important to understand what rights you’re giving to preferred shareholders. One thing I didn’t mention yet is that if you give rights to an investor in say, a seed round, the Series A investors will want the same rights. Venture capital is almost entirely reputation based, as an industry, and a bad reputation can kill deal flow or the ability to work with other funds. This is actually a reason investors can give for not signing NDA’s, too. They can’t keep track of all the technology they look at, and if an investor did take advantage of your good idea, it would be a very bad look for them. The bottom line is, as always, don’t go it alone if you’re looking at a Term Sheet from an investor. An attorney can help you navigate the process and explain share structures and investor rights to you.
