Once you have formed your company and issued shares to your founding team, you are probably thinking about raising money to fund your early operations. Perhaps you have even completed a friends and family financing with a convertible note or other instrument. But what’s next? You have probably heard about preferred equity or preferred stock, but what is it and why do professional investors (angels and venture capitalists) want preferred stock? Understanding the key features of preferred stock and why it is desirable to outside investors is essential for startups.
The founders of a new company normally receive common equity – either common stock of a corporation or common units of a limited liability company. The basic rights of common equity holders are found in the certificate of incorporation or articles of incorporation (which are typically referred to as your “charter”) or operating agreement and typically provide that the holder have the following economic and control rights:
1. Dividends – Each common equity holder has a right to receive dividends if and when declared by the Board of Directors, subject to insolvency requirements of the applicable corporation or limited liability company law.
2. Liquidation Rights – Upon a liquidation and winding up of the company, each common equity holder has the right – after payment of any debts and obligations (including rights owed to any senior security holders) – to receive its pro rata portion of the remaining assets of the company.
3. Voting – Subject to the rights of the preferred stockholders contained in your charter or operating agreement, common stockholders have the right to elect the directors or managers of the company.
Unlike common equity, preferred equity is specially negotiated security, in many ways similar to debt instruments, like a note. Unlike debt instruments, preferred equity is typically part of your charter or operating agreement, which provides the preferred equity holders with special rights, preferences and privileges senior to the common equity. These rights often include:
1. Dividends – Preferred equity holders typically receive dividends either alongside or before payment of any dividends to common equity holders. The preferred equity holders’ dividend right may accumulate over periods and may also compound, like an interest payment. These rights vary from between companies, and sometimes within different series of preferred stock for a single company, depending on the objectives of the company and the investors.
2. Liquidation Rights – For most early-stage investors, one of the most important economic rights is the right to a liquidation preference. A liquidation preference is the right to receive the first dollars out of the company (prior to the holders of common equity or any junior series of preferred equity) upon a liquidation or winding up of the company. Preferred equity holders may receive back their investment amount (along with any accrued dividends) or, sometimes, a multiple of their investment amount. If the assets available upon liquidation exceed the preference amount, sometimes preferred equity holders are permitted to participate alongside the common equity holders (this is called “participating preferred equity,” which may be capped) or, in the event the preferred stock is convertible into common stock, the preferred equity holders may forgo the liquidation amount and participate alongside the common equity holders.
3. Voting – Preferred equity holders often negotiate special voting rights, such as the right to elect one or more directors or managers and special protective provisions, which prevent the company from taking certain actions without the approval of a majority or supermajority of the holders of preferred stock.
4. Redemption Rights – Preferred equity investors sometimes negotiate a right to sell back shares to the company if the company does not exit (either through a public offering of securities or an acquisition) within a negotiated period of time. Redemption rights are intended to protect investors from holding an illiquid investment for longer than acceptable to them, but practice varies based on regional preferences.
The economic and control rights of preferred equity summarized above are generally only the key rights available to investors. Investors may negotiate additional rights, such as registration rights, preemptive rights, and rights of first refusal. Each of these rights provides investors with the ability to protect their investment by controlling key rights without controlling day-to-day operations of the company.