Startup Company Blog : Seattle Startup Lawyer & Attorney : Davis Wright Tremaine Law Firm : Emerging Companies & Venture Capital

 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.

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Founders contemplating an angel financing often ask whether their company should issue common or preferred stock to angel investors. A fundamental difference between the two is that preferred stock has a liquidation preference, which upon a liquidation or sale of the company entitles the holder to a payment prior to distributions to the common stockholders. Thus, from the founders’ perspective it is typically desirable to issue common stock so the founders are on parity with the investors with respect to liquidating distributions. Issuing common stock also results in a simpler capital structure as the company will have only one class of stock outstanding (and thus will not be disqualified from making an S corporation election for having more than 1 class of stock outstanding).

Whether to issue common or preferred stock depends on a number of factors, such as:

• does the entity want to make or maintain S election status;
• the type of investor (friends & family investors will typically accept common stock, while organized angel groups will typically expect preferred stock. (Note, however, that all preferred stock is not the same – a topic for a future post.)

 The relative leverage of the parties can also play a role. If the founders have multiple term sheets from different investors or they can persuade investors that their company has a significant upside potential, they may be able to issue common stock. I recently observed a company decide to go with a term sheet with a lower pre-money valuation than other offers because the investors were willing to accept common stock. The founders felt that the benefit of not granting preferred stock rights, which included the right to block a sale of the company, was worth the slight compromise.

In conclusion, it is typically better for the founders if the company issues common stock to angel investors. Of course, issuing preferred stock in an angel financing is typically better than no angel financing.

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Venture capitalists and sophisticated angels typically insist on receiving preferred stock for their investments in emerging companies. As a result, companies pursuing such investments often ask “what rights come with preferred stock?” First, it is important to recognize that all preferred stock is not the same. Second, preferred stock terms requested by a venture firm may be a bit more onerous than those sought by angel investors.

Typical preferred stock rights and preferences can include:

• Liquidation preference
• Dividend preference
• The right to convert to common stock
• Anti-dilution protection if the company issues stock below the preferred share price
• Blocking rights on significant actions of the company (e.g., company sale, equity financings, increase in option pool, etc.). Sometimes these rights can extend to governance matters such as the right to approve the appointment of senior executives, to incur significant indebtedness, etc.
• Rights of first refusal with respect to transfers of stock by the founders and sometimes other shareholders
• A co-sale right to sell stock on a pro rata basis if the founders sell stock
• Right to appoint a member(s) to the company’s board of directors
• Rights to participate on a pro rata basis in future equity offerings of the company
• Rights to demand that the company engage in a public offering and/or register the investor’s shares for sale into the public market
• Information and inspection rights

The extent to which a company will be required to grant such rights will depend on the context of the financing, including the type of investors (e.g., venture capitalists or angels), the relative leverage of the parties and the rights granted by the company in prior financing rounds. With respect to the last point, a company should recognize that the rights it granted in its last financing round will serve as the starting point for its investors in the current round. These investors will typically get at least those rights or better.

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Q: What is participating preferred stock? What distinguishes it from non-participating preferred stock? Who prefers participating preferred stock, and who prefers non-participating preferred stock?

  A: Participating preferred stock is preferred stock that entitles the holder to a specified preferential payment upon liquidation and a share in any remaining liquidation proceeds on an as-converted to common stock basis. For example, if a company that issued $1 million dollars in participating preferred stock representing 10% of the company liquidated in a transaction for $10 million, the holders of the participating preferred stock would be entitled to receive a $1 million liquidation preference (or more, if specifically agreed upon), plus 10% of the remaining proceeds available for distribution, for a total of $1.9 million. If the same company sold instead for $15 million, the participating preferred stockholders would be entitled to $1 million plus 10% of $14 million dollars for a total of $2.4 million in total distributions.

 

In contrast, non-participating preferred stock is preferred stock that only entitles the holder to the preferential liquidation payment and not a share in any remaining liquidation proceeds. Using the example above, if a company that issued $1 million dollars in non-participating preferred stock representing 10% of the company liquidated in a transaction for $10 million, the holders of the non-participating preferred stock would be entitled only to their $1 million liquidation preference, and the remaining $9 million in proceeds would be distributed to the other stockholders. Note however that if the company was sold instead for $15 million, the holders of non-participating preferred stock would typically elect to convert their holdings to common stock in order to receive 10% of $15 million, or $1.5 million, an amount greater than their liquidation preference. 

 

Thus, from an investor’s perspective, participating preferred stock is preferable to non-participating preferred stock as it both allows for a preferred payment upon liquidation and participation in the upside if the Company is sold at a premium.

 

This article is not intended to be legal advice. You should always consult with an attorney before making an investment. 

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