Most venture investors looking to fund startups will negotiate for preferred stock or shares so they can gain more privileges and rights. These can be particularly useful for mitigating risk and providing anti-dilution protections. But what are they exactly, and in what way do they differ from common stock dividends?
In this article, we will go over everything you need to know about preferred stock, including its benefits, rights, and usual privileges, and why founders need to offer this option to VCs. We have a few things to cover, so let’s get started.
Preferred stocks pay dividends to their holders and grant them special rights. In the event of a liquidation, for example, preferred shareholders will have access to higher claims.
When startup companies are in their earlier stages, they usually issue two types of shares: Common stock and preferred stock. While the first will tend to be the option for founders, the second is intended mainly for venture capitalists. Here’s the difference in a little more detail:
Common shares are the most widely available type and are what you’ll most likely find when trading in an exchange. Even though they come with certain voting rights, if a company goes bankrupt, you would be the last one to get paid. Preferred stock typically includes no voting rights but has higher and more regular dividend payments.
Need to level up your VC skills? We’ve got you covered.
When trying to determine which of the two options are better, one thing to keep in mind is that common stock represents residual ownership stakes. Which means that you have some guarantees in the shape of the company’s assets (owned or entitled), such as equipment, property, accounts receivable, and cash reserves. On the other hand, a balance sheet will also include liabilities; for example, debts, obligations, and payables.
If a company is healthy, you can expect to get good dividend payments (provided the total assets are more than the total liabilities; whatever is left will be shareholders’ equity).
Preferred stocks can give shareholders certain privileges over people who have common stock options. Their main advantage is that they can let them exert some degree of control and limit risk. To understand whether preferred stock is better than common stock, we should first look at its benefits.
There are a few different classes or types of preferred stock investors can acquire. These are:
There are several benefits to owning preferred stock. A primary advantage, as we just mentioned, is the ability to mitigate some risk, but preferred stockholders also tend to have a greater claim to company assets and will get a dividend payment before common stockholders if a company goes bankrupt.
In fact, those holding preferred stock don’t just get paid earlier; the dividend payments are typically higher, too. Let’s go through these and more benefits in more detail and see why preferred options tend to be a good choice for investors.
Preferred shares typically come with attached anti-dilution protections. This means that if the company issues new shares during a fundraising round, the existing shareholders will increase the number of common shares each preferred share converts to (this is sometimes mentioned as convertible preferred stock).
Dilution can happen both if a valuation is reduced or an investor’s shareholding percentage goes down in subsequent fundraising rounds. To prevent the first scenario, you can put mechanisms in place that adjust the price at which preferred shares are converted into common stock. For the second, something many companies do is implement pro-rata rights that give investors the right to participate in future funding rounds so they can keep their percentage.
There are typically two types of anti-dilution protections: weighted average anti-dilution protections and full-ratchet anti-dilution protections. They apply a price based on the weighted average all investors have so far paid or use the lowest preferred share price for all conversions, respectively.
In the case of company liquidation, preferred stockholders will always have a higher liquidation preference when compared to common stockholders. This can happen, for example, if there is an acquisition, a selloff, or an IPO event. What this means is that the people or entities that have preferred stock will be paid earlier – although in almost all cases after debtholders.
There are also two types of liquidation preferences: participating and non-participating. Participating liquidation can be full (during a liquidity event, those involved will receive full preference before any distribution) or capped (stakeholders can only participate until the preferred shareholders receive a specific aggregate amount; the cap is typically x-times the original investment). Non-participating liquidation preference, on the other hand, will give stakeholders the option to receive an amount of liquidation (in addition to unpaid dividends) or convert their portion of the shares into common stock.
For example, let’s suppose an investor puts $3M into a startup that is made up of eight people, including two co-founders. In return, they will get 20% company ownership. The co-founders retain 70%, and the remaining 10% goes to the six employees. If the company sells for $5M, the 20% that corresponds to the investor would be worth just $1M – which means he’d be down $2M! However, if they have a 1x liquidation preference, they would receive $3M.
Common shareholders usually receive one share for each bote when it comes to electing a board of directors (it’s important to keep in mind that the number is not in direct proportion to the shares owned).
Preferred stockholders, on the other hand, don’t typically have voting rights in public companies, although they can negotiate some as part of venture investing. These tend to be similar to those holding common stock and can sometimes include the ability to elect a board of director members.
Investors who choose preferred stock will also often negotiate some protective provisions. For example, to veto any corporate actions that could impact their investment. These provisions sometimes include pro-rata rights, too, which we covered above (pro-rata rights allow investors to keep their stake if a company grows).
Other typical protected provisions for preferred stockholders include:
Company founders do not get preferred stock, but unfortunately, it will be nearly impossible to raise any venture capital if you don’t offer it to potential investors. VCs just won’t be interested in participating in your project if you can’t provide preferred stock.
Something that is worth remembering is that preferred shares are, however, negotiable. This will be defined in more detail in your small print but will usually involve specific rights and liquidation preferences, so they can get paid first. If your company does well, you won’t have to worry about these.
The good news is that deal terms have become quite standard, and they tend to favor founders. This is because there is a lot of capital available, so entrepreneurs can have more leverage. Most investors will expect a “1x non participating” liquidation preference, which means they receive $1 for every $1 invested, recouping their money if anything goes wrong. That is, as long as there is enough money to cover this payment. The “non participating” part, as we saw, means that the investor has the choice to instead convert their preferred stock into common stock.
Many investors will also expect anti-dilution provisions so they can be protected against their percentage becoming diluted in future rounds. Their stake will be maintained, but the specific details will depend on the situation and what your agreement says.
In any case, the one thing you should be wary of if you are a founder is what’s called “double dipping” or “participating preferred shares”. If an investor has it, they will be the first ones to recoup their investment in the case of a liquidation and pocket any additional proceeds that remain proportionally to their ownership stake. For example, if a company sells for $200 million, a participating preferred investor could take an original $40 million plus 20% of the remaining $160 million.
What’s important to remember is that you can always negotiate preferred shares. In a bull market, it’s unlikely you will get bad terms, but it’s best to tread carefully nonetheless.
Startups typically issue both common and preferred stock, although it’s the second that most investors will be interested in getting. Preferred shares, as we saw, offer several advantages to VCs; for example, they can help them mitigate risk. Typically, preferred stockholders will get higher liquidation preferences, anti-dillution protections, and protective provisions that allow them to limit decisions that can impact their investment.
Not all preferred stock is the same, and you’ll always be able to negotiate a deal that works for everyone involved. If you are a founder, the best thing you can do is focus on hitting your milestones and building a great product that will interest investors. Like all negotiations, preferred stock is a leverage game. So, if you build something you love, others will love it, too.