Preferred Stock 101: Quick Guide For Startup Founders

Preferred Stock: Quick Guide For Startup Founders

Preferred stock is a crucial aspect of raising capital for startup founders. Understanding its features, benefits, and implications is essential for any entrepreneur seeking funding from venture capitalists (VCs) or angel investors. In this article, we will provide a comprehensive guide to preferred stock, its key features, and why it is a preferred investment option for VCs. Let’s delve into the world of preferred stock and its significance for startup founders and investors alike.

What is Preferred Stock?

Preferred stock, also known as preferred shares, represents ownership in a corporation but differs from common stock in several key ways. While common stockholders have voting rights and potential for high returns, preferred stockholders enjoy priority treatment when it comes to dividends and liquidation events. Preferred stockholders often have a fixed dividend rate and a higher claim to company assets compared to common stockholders.

Preferred stock offers a hybrid form of equity and debt in terms of its characteristics. This unique structure attracts both investors seeking the potential for capital appreciation and stability in the form of fixed dividends. Startup founders commonly issue preferred stock when raising funds as it provides a fair balance between investor expectations and entrepreneur control.

Preferred Stock in Startups vs Public Companies

In startup companies, preferred stock often takes different forms compared to publicly traded companies. While public company preferred stock might mirror the dividends and liquidation preferences seen in startups, startups tend to have more complex preferred stock structures.

Startup preferred stock typically contains additional features to protect investor interests and align incentives between founders and investors. These features encompass convertible preferred stock, liquidation preferences, anti-dilution protection, participating preferred stock, and more. Let’s explore these features in detail.

Reasons Why VCs Want Preferred Stock

VCs are highly interested in investing in preferred stock due to the various benefits it offers. Preferred stock provides VCs with a level of security and potentially higher returns compared to common stock. As VCs take higher risks by investing in early-stage companies, they seek preferred stock to protect their investments and maximize returns in case of a liquidity event.

Additionally, preferred stock allows VCs to influence startup decision-making processes by offering voting rights, board seats, and protective provisions. These features enable VCs to have a say in critical matters and ensure their investments are safeguarded. Overall, preferred stock is an attractive investment option for VCs as it aligns their interests with those of the startup founders.

Preferred Shares Features: Most Preferred Deal Terms are Increasingly Standard

When investing in preferred stock, both investors and founders negotiate specific deal terms. Over time, many of these terms have become increasingly standardized in the startup ecosystem. Let’s examine some of the key features commonly found in preferred shares agreements.

Convertibility of Preferred Stock

One of the most valuable features of preferred stock is its convertibility option. Convertible preferred shares enable investors to convert their holdings into common stock at a predetermined conversion ratio. This provision allows investors to enjoy the future growth and potential success of the company without sacrificing initial investment protection. Notably, the conversion ratio ensures that investors are appropriately compensated for the risk they took.

Preferred Stock Liquidation Preference

Another important feature of preferred stock relates to liquidation preferences. Liquidation preferences grant preferred stockholders a specific claim on company assets in the event of a liquidation or acquisition. It ensures that preferred stockholders receive their investment amount back before common stockholders participate in the distribution of remaining assets.

For instance, let’s consider a startup with $10 million in preferred stock and $20 million in common stock. If the company is sold for $30 million, those holding preferred stock with a 1x liquidation preference would receive $10 million, ensuring they recover their initial investment. On the other hand, common stockholders would receive the remaining $20 million.

Some preferred shares may have additional liquidation preferences, such as 2x or 3x, which grant even more significant advantages to preferred stockholders. These preferences offer a level of downside protection to investors, making preferred stock an attractive investment option.

Preferred Stock Anti-Dilution Protection

To protect against dilution, preferred stock often includes anti-dilution provisions. These provisions aim to maintain the proportionate ownership of preferred stockholders in the company, even in cases where new shares are issued at a lower price than the original investment.

Anti-dilution provisions can be either full-ratchet or weighted-average. In a full-ratchet scenario, the conversion price is adjusted based on the lowest price at which new shares are issued. Weighted-average provisions take into account the new and old share prices, striking a balance between preserving investor ownership and not overly penalizing the company.

Participating Preferred Stock (Also Known As “Double Dipping”)

Participating preferred stock provides holders with the right to receive both their initial investment amount and a proportionate share of the remaining proceeds during a liquidity event. This feature allows preferred stockholders to benefit twice: once through the liquidation preference and again through their proportionate share of remaining proceeds after common stockholders are paid.

The double-dipping nature of participating preferred stock helps compensate investors for the increased risk they assume compared to common stockholders. However, this provision can significantly impact the amount of proceeds available to other stakeholders, such as common stockholders and founders.

Preferred Stock Dividends (cumulative vs. non-cumulative)

Preferred stockholders typically receive dividends before common stockholders. These dividends can either be cumulative or non-cumulative.

In the case of cumulative dividends, if a company fails to pay dividends in a particular period, those unpaid dividends accumulate and must be paid before any dividends are distributed to common stockholders. Non-cumulative dividends do not accumulate, which means any missed dividends are lost and cannot be claimed in subsequent periods.

Cumulative dividends offer greater protection to preferred stockholders but can weigh heavily on startup finances. Founders should carefully consider the impact of cumulative dividends when negotiating term sheets with potential investors.

Callable Preferred Stock

Callable preferred stock allows the issuer to repurchase the shares from investors at a predetermined price within a specific timeframe. This provision can be beneficial for companies that want to optimize their capital structure or restructure their ownership. However, callable preferred stock introduces uncertainty for investors, as it provides an opportunity for the company to redeem shares before expected. Preferred stock that is callable is rare in typical venture deals.

Protective Provisions for Holders of Preferred Stock

Protective provisions in preferred stock agreements safeguard investor interests by granting veto rights on significant corporate actions. These provisions can cover areas such as changes to the company’s structure, mergers and acquisitions, issuance of additional shares, or the modification of investor rights. Protective provisions provide investors with a level of control and influence over the company’s strategic direction and help maintain the original terms of the investment deal.

Pro Rata Rights for Holders of Preferred Stock

Pro rata rights enable preferred stockholders to maintain their ownership percentage in subsequent financing rounds. This feature gives investors the opportunity to participate in future rounds of funding in proportion to their existing ownership. Pro rata rights ensure that preferred stockholders have the opportunity to preserve their position and maintain their influence in the company’s growth.

Preferred Stock: Board Seats and Voting Rights

Preferred stockholders often have the right to elect representatives to the company’s board of directors. This provision ensures that preferred stockholders have a voice in key decision-making processes. The number of board seats allocated to preferred stockholders can vary depending on factors such as the investment amount, the ownership percentage, and the specific terms negotiated between the company and its investors.

Voting rights associated with preferred stock can also play a significant role in shaping company decisions. Startup founders should carefully consider the potential impact of voting rights on their control and autonomy when issuing preferred stock.

Common Stock vs. Preferred Stock

While preferred stock provides a range of benefits to investors, common stock is also an essential component of a startup’s equity structure. Common stock represents basic ownership in a company and often provides voting rights to stockholders. While common stockholders have the potential for higher returns, they also bear more risk compared to preferred stockholders.

Startup founders often hold common stock to maintain control and decision-making power over their companies. However, the dilutive impact of multiple funding rounds can significantly reduce founders’ ownership percentage over time. Balancing the ownership and control dynamics between common stock and preferred stock is critical for founders when deciding how much equity to allocate to preferred stock investors.

Why Companies Need to Offer Preferred Stock to VCs

For startups looking to attract venture capital funding, offering preferred stock is a common practice. Preferred stock serves as a powerful tool to entice investors by providing them with attractive investment features and protections. By offering preferred stock, companies can secure their initial funding rounds while allowing for future growth and subsequent funding rounds.

Moreover, preferred stock allows founders to align the interests of new investors with their own. This alignment strengthens the partnership between founders and VCs, as both parties are invested in the long-term success of the company. The flexible nature of preferred stock terms ensures that founders and investors can negotiate a fair deal that suits their respective needs and expectations.

Why VCs Hope that They Will Get the Common Return

While preferred stockholders enjoy various advantages, VCs ultimately aim for a common return on their investments. A common return refers to the potential for significant capital appreciation upon the successful exit or initial public offering (IPO) of the startup. This common return allows VCs to maximize their financial gains and generate a positive return on their investment portfolios.

While preferred stockholders may have priority when it comes to dividends and liquidation, VCs understand that the true value lies in capturing substantial multiples on their initial investments. VC investors actively seek out high-growth startups that have the potential to disrupt industries, allowing for exponential returns on invested capital.

Preferred stock plays a crucial role in the world of startup financing. Its unique features provide VCs with a level of security and potential upside, while also offering startup founders the ability to raise capital while maintaining control. The specific terms negotiated in preferred stock agreements ensure alignment and mutual benefit for both parties. Startup founders should carefully consider the implications and benefits of preferred stock when fundraising and making decisions that impact ownership and control in their companies.

How can Eton help?

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President & CEO

Chris co-founded Eton Venture Services in 2010 to provide mission-critical valuations to venture-based companies. He works closely with each client’s leadership team, board of directors, internal / external counsel, and independent auditor to develop detailed financial models and create accurate, audit-proof valuations.

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