In the Start-Up Entrepreneur Series, I will be taking a deeper look into some of the most common questions early stage founders face in putting together and operating their new businesses.
Unless your new start-up is fully capitalized by its Founders, one of the first questions a new company must ask itself is “How are we going to fund this thing?”.
Last week we discussed the most common preliminary funding mechanism: “convertible debt“. Today, we’ll talk a bit about the primary form in which institutions invest in start-ups: “preferred stock”.
What is Preferred Stock?
As we’ve talked about in past posts, ownership of a corporation is divided into shares of stock. As the name implies, holders of such shares are entitled to “share” in the value of a company, which such value is distributed either as it is earned (“dividends”) or when the company is sold (“liquidation”).
When a company is initially formed, all of its shares are designated as “common”; meaning that there is nothing to distinguish any one share from the other. Each share of common stock receives its pro rata portion of the assets of the company (whether in dividend or liquidation), and each share of common stock has a pro rata right to vote (“one share, one vote”) on matters before the company’s stockholders.
When institutional investors (e.g., venture capital firms, specialized banks, private equity groups, hedge funds, etc.) become interested in a company, however, such investors seek rights over and above those held by the common stock.
Those rights are the “preferred” in “preferred stock”.
The primary right afforded to holders of preferred stock, and the one that gives the concept its name, is the right to receive a liquidation preference. As one might surmise, a “liquidation preference” is a payment made by a company upon liquidation to the holders of its preferred stock before any payment can be made to the holders of its common stock (or any other series “junior” to the preferred stock in respect of such preference).
There are two primary components of the liquidation preference concept: (i) the amount of such preference, and (ii) whether or not the preferred stock receiving such preference may “participate” in distributions made by the company after such preference has been paid.
In respect of the first component, the most common preference amount is “1X”. With a “1X” preference, the preferred stock investors would receive as preference an amount equal to their initial investment (plus earned dividends; see below) before the common stock holders receive anything. This amount can be higher (2X, 3X, etc.) depending on the leverage of the parties negotiating terms, but really cannot be lower.
In respect of the second component, the question is whether the preferred stock receives its preference in lieu of distributions in excess of such preference or in addition to such distributions. Obviously, the latter can be far more lucrative for the investor (and more expensive for the company’s common holders), but, as is the case in setting the initial preference amount, whether or not the investors receive “participating” stock is largely a matter of the leverage of the two sides.
(Note that while it may not be immediately clear why one would invest in a “1X, non-participating” series of stock, since the only apparent upside is the return of capital, the presence of dividends and conversion rights can still make such an investment attractive. Charting of hypothetical exit amounts can help both Company and Investor understand the various preference options here.)
From the Company’s standpoint, the most important thing to consider in negotiating preference terms is the “overhang” that the preference places on the common holders (which are very likely to be the Founders, and the folks most responsible for the day-to-day success of the enterprise). Those common holders will generally not get paid unless and until the price of the Company exceeds the sum total of all liquidation preferences. In other words, the more preference that is sold, the smaller the pie for the Founders (and Company employees).
As mentioned above, it is worth noting in respect of liquidation preference calculations that virtually all series of preferred stock have the right to convert into common stock at the holder’s option. Because of the additional rights held by the preferred stock over the common, this right is not often directly exercised, but it can and does come into play in respect of non-participating series of preferred if the Company has a very profitable exit.
(Note also that conversion rights are the primary means through which preferred holders protect themselves from potential dilution events. For more on that process and the terms that govern it, see here.)
Dividends are the “interest” that the holders of preferred stock receive on their initial investment.
Generally established as a percentage (between 6-12%) of such initial investment, they can be “cumulative” (i.e., earned whether or not “declared” by the company’s management) or “non-cumulative” (i.e., only paid when the company is otherwise paying dividends). They are almost always paid prior to any dividends on the common stock.
In addition to the economic rights discussed above, the holders of preferred stock very often negotiate for certain powers in respect of the management and operations of the Company. These rights can take the form of, among other things, seats on a corporation’s board of directors, the right to have certain company actions (such as mergers or additional equity sales) approved by the preferred stockholders (rather than all of the company’s stockholders taken together), and the right to receive special informational reports from the company’s officers.
While not as clearly at cross-purposes to the interests of the common holders as the more economic rights, it is important for both the Company and its Investors to consider carefully how agreements on such governing control will impact the Company’s future operations.
As was the case when discussing convertible debt offerings, it is important for the Company to note that the issuance of securities such as preferred stock must comply with U.S securities laws. For most start-ups, that means finding an exemption to the registration requirements of such laws for small private offerings to sophisticated investors.
Even exempt offerings often have certain nominal filing requirements, however, which very often must be complied with on a very tight time-frame to the Company’s fundraising efforts. It is important for companies to consult with counsel on such issues if and when they raise funds, if only to talk through the implications of compliance.
This post is merely an overview tailored as part of the “Start-Up Entrepreneur Series” to give the start-up entrepreneur a taste of what to expect if and when they go out offering Series A stock in their new company. There are many, many more terms that will govern the Company/Investor relationship when it comes to such financing efforts.
For more in-depth analysis of virtually every aspect of such a financing, be sure to check out our Financing Term Sheet Deep Dive Series. (I’ve linked a few of the most pertinent posts above). In that series, we break down all of the major terms contained in a financing term sheet, touching on all aspects of preferred stock and its associated rights.
As always, if you have any insights on today’s post or would simply like to discuss further, please leave a comment down below or contact me at firstname.lastname@example.org. I’d love to hear your thoughts.