Why Do Companies Issue Preferred Stock?
Preferred Stock is stock which is "preferred" over common stock in any number of different ways. For example:
- preferred stock may be entitled to dividends before common stock;
- preferred stock may have special voting rights (protective provisions; the right to block a subsequent financing or sale transaction);
- preferred stock may have the right to be paid first a certain fixed or formulaic amount of money before the common stock on a liquidation or merger of the company into another company;
- preferred stock may be redeemable at the option of the holder after a certain period of time; or
- preferred stock may have a purchase price protection mechanism built into it--such that if the company issues additional stock in the future at a price per share lower than the price per share of the preferred stock, the preferred stock's purchase price will in effect be reduced on the subsequent stock sale.
Preferred stock may have any one or more of these characteristics. In addition, preferred stock holders may desire contractual rights in addition to the rights specified above--such as:
- a voting agreement with the other stockholders, ensuring the preferred stockholders representation on the company's board of directors;
- registration rights;
- the right to receive financial statements or other information on a regular basis;
- preemptive rights on future stock financings;
- rights of first refusal on sales of founder stock;
- co-sale rights on founder stock;
- drag along rights; and
- others.
Companies issue prefer stock for any number of reasons, but most typically, because their investors demand it. For an example of a Series A Convertible Preferred Term Sheet, see the National Venture Capital Association's model legal forms page.
