Preferred Stock has preferences over shares of common stock, preferences that give shares of preferred stock superior voting and economic rights over shares of common stock. For this reason sophisticated investors purchase shares of preferred stock in startups, leaving the shares of common stock for the founders, management and employee options.
Purchasing preferred stock is the standard for sophisticated angel investors and venture capital firms. Preferred stock is a different class of stock than the common stock owned by the founders, management and employees. Preferred stock is superior to common stock because—it has preferences. The preferences fall into five potential categories:
The liquidation preference of preferred stock on a liquidation of the company, including a “deemed liquidation” which is a sale of the company, generally means holders of preferred stock get their money back (plus any declared or accumulated dividends on such shares of preferred stock, see below under “Dividend Preference”) on a sale of the company prior to the holders of common stock getting anything. See related blog post Term Sheet 101, The Liquidation Preference. In addition, the liquidation preference may also be “participating”, meaning that, after the holders of preferred stock get their money back on a sale of the company, they will “participate” ratably with the owners of common stock on any remaining sale proceeds on a pro-rata share basis. See related blog post Participating Preferred Stock.
The dividend preference generally means that the holders of preferred stock may be entitled to the payment of a dividend on their shares of preferred stock before the holders of common stock would be entitled to receive a dividend. Like the liquidation preference participation feature, the dividend preference stock may also contain participating rights entitling the holders of preferred stock to participate with the holders of common stock on any payment of dividends to the common stock on a pro-rata share basis. Another wrinkle of the dividend preference is that the dividend preference may be cumulative or non-cumulative. Dividends have to be declared by a corporation’s board of directors in order to be paid; they cannot be mandatory. With cumulative dividends, if the dividends are not declared by the board of directors and paid, then they will cumulate (accrue) over time, can build up to a substantial amount, and are included in the liquidation preference of preferred stock.
The conversion rights almost always provide that the preferred stock is convertible into shares of common stock. Shares of common stock have unlimited upside (think of Google or Apple stock). Because shares of preferred stock are convertible into shares of common stock, shares of preferred stock also therefore have unlimited upside. Shares of preferred stock will also most likely have “anti-dilution rights”. Anti-dilution rights protect investor against future sales of stock at a price below the price they paid. When that happens, the anti-dilution rights kick in and adjust the rate at which the preferred stock is convertible into common stock to give the holders of preferred stock more conversion shares of common stock. See related blog post Term Sheet 101, Price Based Anti-Dilution.
Redemption rights provide either optional or mandatory redemption (repurchase) of the shares of preferred stock by the company from the holders of preferred stock in order to guaranty liquidity after a certain period of time. It is typically unusual to see redemption rights in early-stage seed and angel preferred stock financings. In later financings with venture capital investors, when redemption rights are present, they will be at the option of the investors after 5-7 years.
Class voting rights for the shares of preferred stock are what give the investors holding preferred stock greater control over the company. In many cases, even if the investors do not own a majority of the shares of the company they have invested in, they can have effective control of the company through the voting preferences of the preferred stock. These preferred stock voting preference fall in to two categories. First, the holders of preferred stock can have a separate class voting right to elect one or more members of the corporation’s board of directors. Second, the investors purchasing preferred stock can inject certain veto powers, called “protective provisions”, prohibiting the corporation from doing certain things, such as selling the business or raising more funds, without a separate class vote of the holders of preferred stock.
Through these categories of preferences the investors change the structure of the economics and control of the company. See related blog post: Less Risk, More Reward. A lack of a majority of the stock does not mean that the investors lack control of the company or will receive a smaller piece of the pie when the company is sold.
Our view is that money is still the precious commodity; investors deserve to get preferred stock and companies shouldn’t oppose selling investors preferred stock. Having said that, the terms of the preferred stock are fertile ground for negotiation, and smaller transactions warrant fewer of the “bells and whistles” available to investors under the preferred stock structure.