June 19, 2023
By Luciana Jhon Urrunaga, Esq. and Anibal Manzano, Esq.
One of the decisions founders must make when issuing new shares of equity in their company to investors, employees, or cofounders is what type of stock to issue to each of these stakeholders. Typically, high-growth startups divide their stock (or equity interests in the case of companies not structured as corporations) in two types of shares — common stock and preferred stock. Each type has its own set of rights, benefits, and disadvantages. Both preferred and common stock grant the holder partial ownership over a company; however, they each grant different economic and control rights. In this article we discuss the key differences between common and preferred stock in the context of private, high-growth startups.
Investors (e.g., venture capitalists, angel investors, and private equity firms) will usually negotiate to purchase preferred stock when they finance a company in the context of priced rounds (equity financings). The same logic applies to financings in which investors purchase convertible instruments, such as Simple Agreements for Future Equity (SAFEs) or convertible promissory notes, both of which are usually convertible into shares of preferred stock. Preferred stock affords investors key benefits that allows them to offset some of the high risk of investing in early-stage companies.
The key trait of preferred stock is its liquidation preference, which is senior to common stock. This means that in the event the company is sold or is liquidated, dissolved, or wound down, holders of preferred stock will be paid out, usually one times (1x) their investment, before the common stockholders, because they have a higher priority claim to any company assets that must be distributed to shareholders in a liquidity event. Still, preferred shareholders don’t rank equal to company creditors, who are senior to all stockholders (including preferred stockholders). The liquidation preference relates to priority amongst stockholders.
A 1x liquidation preference is usually standard in venture financings, but multiples (1.5x, 2x, etc.) may increase based on market conditions. Liquidation preference multiples are a key deal term in venture financings, and founders should be well-educated on the economic rights conveyed by this term to negotiate effectively.
There are two types of liquidation preferences—participating and non-participating. Preferred stock that affords a participation right is usually referred to as “participating preferred stock” or “double dip” preferred stock. Preferred stock that does not afford a participation right is usually referred to as “non participating preferred stock”.
Like many things in life, the devil is in the details; and, in the case of participating vs. non participating preferred stock, it comes down to an “and” or and “or”. Each share of preferred stock is typically convertible into one share of common stock. With non participating preferred stock, investors will receive the greater of (a) the price they paid to purchase the preferred stock OR (b) the amount payable to preferred stockholders assuming the preferred stock is converted into common stock as of immediately prior to the liquidity event (i.e., the exit). With participating preferred stock, investors will receive both (a) the price they paid to purchase the preferred stock AND (b) the amount payable to preferred stockholders assuming the preferred stock is converted into common stock as of immediately prior to the liquidity event (i.e., the exit).
Liquidation preferences are viewed as fair to investors and companies by many practitioners because they give protection in priority (relative to founders and other service providers) to the company’s cash investors, which is usually captured in a balanced manner via non participating preferred stock. Nevertheless, it’s important to understand that, although some terms may seem unfair in certain circumstances, they can be appropriate and balanced in many others, which is why it is important to rely on experienced counsel.
Holders of preferred can typically vote their shares of preferred stock as converted to common stock. However, VCs usually purchase between 10% and 30% of the company’s stock in connection with a financing, which does not give them a majority of shares required to control the company. VCs, nevertheless, control the company (to an extent) by negotiating rights to appoint a board member (usually referred to as the “Preferred Director”) and require that certain matters be approved by the preferred stockholders or the Preferred Director, as follows.
The board of directors is a company’s governing body that oversees its management and determines its major strategic decisions. As such, control of the board is coveted by both investors and founders. In connection with a preferred stock financing, the lead investor typically seeks to obtain one or more board seats that will be elected by only the holders of preferred stock. While common stockholders would continue to vote for other members of the board, depending on the number of board seats that preferred investors are awarded, founders may find that they have lost control of their board following one or more rounds of financing.
Protective provisions give preferred stockholders power over certain major decisions that may affect them directly, like selling the company. They are provisions in the company’s certificate of incorporation that require certain decisions or transactions be approved by a certain percentage of the holders of the preferred stock. Protective provisions can cover transactions that already require stockholder approval, or they can require approval of transactions that would not otherwise require stockholder approval, such as increasing the size of the board of directors or incurring debt over a specific amount.
Similarly, investors may negotiate that certain matters need to be approved by the Preferred Director, instead of the preferred stockholders by arguing that these matters are not fundamental to the company, but that are sufficiently strategic to warrant board approval. Depending on the composition of the preferred class (i.e., does one stockholder hold a majority of the preferred stock?), these matters could grant stockholders that designate the Preferred Director board powers.
Anti-dilution protection provisions protect investors against dilution by future investment rounds. Dilution can take place in the form of a “down round” where the company issues shares at a valuation lower than that of previous rounds. To protect against “down round” dilution, investors can negotiate for a mechanism that adjusts the conversion price of the preferred shares, aiming for a higher conversion rate of the preferred stock into common stock than previously issued.
For example, a share of preferred stock that previously converted into one share of common stock might convert into 1.5 shares of common stock. This anti-dilution mechanism come in two forms: (i) full ratchet, which reduces the conversion price of the existing preferred stock to the price of the stock being sold in the new financing, and (ii) broad based weighted average (BBWA), which adjusts the conversion price of preferred stock based on a calculation that considers both the price of the new shares being issued and the number of shares being issued. Full ratchet provisions are considered punitive and rarely included, except in special circumstances. BBWA is by far the norm in venture financings.
Another type of dilution is simply when an investor’s shareholding percentage is reduced by a subsequent fundraise (even if the valuation of the company has increased) because a higher number of shares are outstanding. To protect against this type of dilution, investors are commonly given pro-rata or participation rights, which gives them the right to invest in future rounds proportionally with their current shareholding to maintain their shareholding percentage. Of course, this assumes that these existing investors will invest new money in connection with subsequent financings.
A dividend is a share of a company’s profits paid out regularly in cash to its shareholders. High-growth startups rarely declare cash dividends while the company is private. Therefore, while it’s true that preferred shareholders may have a higher-priority claim to dividends and must receive a dividend payment before common shareholders are paid out, high-growth startups rarely declare cash dividends, as they typically invest any available funds back into the company to accelerate growth. Even if a startup was one of the rare exceptions that paid dividends to its stockholders, different classes of preferred stockholders will have different rights and levels of priority.
Shares issued by a company must either be registered with the Securities and Exchange Commission (SEC) or fall under an exemption to registration. Private companies often rely on an exemption from registration and do not register their securities. As such, investors hold unregistered shares that have certain restrictions, notably, restrictions on the shareholder’s ability to resell the shares. Investors can negotiate for certain registration rights that will require the company to register the investors’ shares at some point in the future to facilitate resales.
Common stock is generally issued to founders and early employees either directly or via stock option grants, which give employees a right to exercise (buy) those shares at a set price after a set vesting period. Because common stock is usually sold at the fair market value (which is often times a nominal amount with startups), there is a higher potential for capital gains for common stockholders.
Because common stockholders come last in liquidation preference, they are less likely to receive payment following a liquidation, sale, or bankruptcy. Importantly, common stockholders have voting rights, which typically allow them to elect the company’s board of directors, who decide the strategy and oversee the management of the company. However, not all common stock follows the simple “one share, one vote” formula, as a company can have different classes of common stock with different votes per share.
Anibal Manzano is a corporate lawyer who specializes in venture capital and startup law, mergers and acquisitions, and cross-border transactions connected to the United States and Latin America. He is based in Boca Raton, Florida and regularly represents startups and investors in connection with venture capital financing transactions and related corporate and securities matters.