What do the different share classes mean for me and my startup?
There are a lot of different share classes out there, so in an attempt to demystify all the jargon floating around, here is a rundown of all the common names and the typical features associated with each.
A note about language. One of the odd peculiarities between Canadian and US companies: in Canada, a unit of equity ownership in a company is called a “share,” while in the US a unit of ownership is called “stock.” Another oddity is in the US you can have as many classes of stocks, in Canada they are called series; Series A (Can) vs. Class A (US). Bottom line, stocks and shares are the same thing. From here forward, I’ll refer to everything as shares.
Hydrogen, Oxygen, and Carbon: the common elements
The most basic unit of ownership of a company. Many companies’ entire ownership structure, or capital table (often shortened to cap table), is made up entirely of common shares.
Common shares have the lowest priority in the event of a situation where proceeds must be distributed between shareholders. Obviously, if there is no debt or other share classes in the company then low priority doesn’t matter.
Common share ownership also comes the right to vote those shares, typically to appoint a board of directors and the auditors.
Non-voting common shares
These shares share all the economic interest of common shares; importantly, they are no lower on the priority of distribution than common shares. However, these shares don’t get to vote the board of director or auditors. The real effective difference between commons and non-voting commons is that no notices need to be sent to non-voting shares since they aren’t in a position to vote on any matters coming before the shareholders of a company. As such, these shares typically have limited information rights as well.
Non-voting common shares (NVCS) have effectively become the standard form of equity compensation to employees through equity compensation plans via options, as they impart all the economic benefit to employees without burdening the company with a shareholder logistics early on, when startups simply can’t afford to build an investor relations team. Non-voting shares are an excellent compromise for both parties.
As an employee, how do you get your hands on those NVCS? Through options! Because of this nasty thing called capital gain and taxes, startups can’t just give shares to employees. This is because you, as the employee, would be receiving a financial benefit, and would need to pay taxes as a short-term capital gain. Startups and their employees don’t tend to be cash-rich, so paying taxes in cash for something that may or may not have value years in the future seems like a recipe for disaster, and at the very least just a bad idea.
Enter options. Effectively, what the company is doing is giving you the right to buy shares in the future at today’s price. Since the difference between that price today is zero, from the tax man’s perspective what you received isn’t worth anything, and therefore not taxable!
As the company grows, the value you can buy those shares at, via your option, doesn’t change. So the options value does go up with time. As mentioned, most options today are an option to purchase NVCS. Option holders will typically convert, or exercise, their options when there is a liquidity event, effectively tying a personal taxable event to a cash distribution.
In their simplest form, a Preferred Share has some preference over common shares. In the public markets, this preference is most typically a dividend that must be paid out in preference to any dividend to common shares.
In the private markets, including venture capital, where dividends are neither expected nor advised (see below), that preference typically comes in the form of a right of return of capital, in a distribution event, or converting to common and participating equally with everyone else. Preferred shares also typically come with a number of financial controls, a right to a board seat, regardless of how small their overall voting pool is as compared to the overall number of outstanding shares, and a few other rights.
Investors ask for these shares when investing in a company as it gives them some peace of mind that in the event of a positive outcome, everyone wins equally, and in a negative outcome, they can recover some, if not all, of their invested dollars.
To further add confusion, public market preferred shares typically don’t have any voting right, in stark contrast to the private market preferred shares which absolutely do.
Uranium, Plutonium, other reactive elements
Super voting common shares
Still relatively rare, these are a form of common shares that, like non-voting shares, have the same economic interest in the event of a distribution to shareholders as common shares. However, these shares get to vote multiple times per share, often 10 times or more for each share owned.
This allows founders to effectively retain control over the company even after significant dilution. Google and Facebook are both examples of companies with dual-class shares where founders and insiders shares have super voting rights.
Participating (preferred) shares
Participating shares are like Preferred shares except that the economic outcome in a distribution is the Participating shares receive their money back and then share equally with all other share classes. This is often called double dipping. Participating shares also tend to have either a dividend or guaranteed rate of return as well (see below).
The longer the time between the investment and the liquidation event, the less of the pie the common holders will get at an exit. This, in and of itself, isn’t a necessarily a bad thing. What is happening, though, is the investor is lowering the effective pre-money valuation in all but the best outcomes.
Let me walk you through two examples:
- Base case, using a simple preferred share, an investor puts $2 million into an $8 million pre-money valuation. The post money for ACME Inc. is $10 million. A happy exit takes five years. Assuming an exit of $50 million, the investors make $10 milion and the founders make $40 million. Everyone is happy.
- Now let’s turn that preferred share into a participating preferred. The investors walk away with $11.6 million and the founders $38.4 million. Still sounds good, but the effective pre-money was $6.62 million! That’s a 21 percent discount compared to pre-money in the term sheet. If the exit is even lower, say $20 million, that pre-money is effectively $5 million, 56 percent lower!
Only when the exit numbers get very large, do the real pre-money valuations converge. The VC trying to sell you on a participating share structure will do their best to sell back to you the vision of multi-billion dollar exists. You’ve been warned.
Multiple liquidation (preferred) shares
Multiple liquidation preference is similar to participating. Effectively what this says is: the investors get a multiple of their invested capital before anyone else gets any money back. The most basic version comes in a non-participating form that has a two-times multiple. More aggressive investors will go for even more significant multiples.
In our example above, on a 2x liquidation preference, the investor would get back 4M or, if the exit was $50 million, would simply participate with the common shares as if they never had any liquidation preference. If the exit was below $20 million, they would take their $4 million, again creating a situation where the pre-money was effectively lower than what was on paper. At a $15 million exit, the pre-money was really worth around $6.5 million.
Participating multiple liquidation (preferred) shares
Pure evil. Plain and simple.
In our participating example, adding a 2x liquidation preference turns $2 million on $8 million investment with a $50 million exit into a $13.3 million windfall for the investors, 30 percent higher, and an effective pre-money valuation of $6.7 million, 43 percent lower than the base case.
When an investor shows up with a large pre-money valuation, but with participating multiple liquidation preference — be extremely wary of what they are selling.
In all the examples above, I assumed no dividends. However, often investors like to further financial engineer deal terms by having a quarterly dividend. This dividend, of course, is not paid out. Instead, the value accrues and compounds over time. The total value of the dividends is added to the capital invested number, raising the hurdle number for a preferred return, participating return and/or multiple base. Example: a $2 million investment over four years ends up being treated as if it was $2.9 million originally invested.
All investors are effectively doing is juicing their returns and lowering the effective pre-money valuation, similarly to all the prior examples. Dividends seem innocent, but they aren’t!
Like options, warrants are simply a right to purchase shares, most typically common shares, sometime in the future at a set price. Unlike options, which are most typically issued as part of a compensation package, warrants are almost always acquired via a purchase mechanism, such as part of a fundraising process. Given warrants are not typically a tax planning tool, they can be exercisable at a whole host of prices (recall, options are almost always exercisable at the price of the last round prior to their issue).
We don’t typically see warrants in venture capital deals because they effectively operate a bit like an uncapped liquidation preference. Uncapped in that, you may be buying 30 percent of the company for $2 million instead of 20 percent, using our prior example. Warrants are just another financial engineering tool.
Financial engineering of deal terms is almost always refractory to future valuations, rather than additive. Founders and their teams are giving up long-term real benefits for a short-term perception of gain (a high pre-money valuation). This is a toxic trade.