When startups raise funds, accounting for equity, including preferred stock, matters since VCs and future investors will look to the company’s financial statements - specifically the balance sheet - to understand the company’s capital structure. In startup accounting, understanding and accurately reflecting the nature of preferred stock on the balance sheet is essential for transparency and compliance.
As highly experienced startup accountants (our clients have raised billions in early-stage VC funding), we record scores of new investments in our clients a quarter, so have a lot of experience understanding both what GAAP calls for when accounting for a preferred stock investment, what VCs expect to see and what is practical for early-stage startups to actually be responsible for on their financial statements.
Generally Accepted Accounting Principles (GAAP) provide a standard method for accounting for preferred stock. Preferred stock is accounted for as equity. Under GAAP, the equity section of the balance sheet should include:
While APIC calculation is straightforward for large companies, it can be challenging and less relevant for early-stage startups.
Under GAAP, direct costs related to equity fundraising, such as legal fees, should be capitalized and offset against APIC. There’s no requirement to amortize these costs as they are considered permanent equity costs. This can be a bit confusing, as this means that the legal costs don’t flow through the income statement as a normal expense.
Investors often prefer a simpler view of the equity section. This method involves:
This approach is cost-effective and straightforward, making it easier for investors to understand the financials of the startup.
Professional startup investors almost always get preferred stock. This is for a variety of reasons - but mainly due to its ability to reduce investment risks and increase control over company decisions. Founders should work with experienced startup attorneys when negotiating a VC round so that they make sure the VCs purchase plain vanilla preferred! Typical advantages of this kind of stock that VCs get include:
Preferred Stock: Reduced Risk and Increased Control for Investors
Preferred stock is a type of equity that is particularly appealing to venture capitalists (VCs) due to its ability to reduce investment risks and increase control over company decisions. Here’s a closer look at why this form of stock is so attractive to investors:
Liquidation Preferences: This is a major draw for VCs. If a company faces liquidation or bankruptcy, preferred stockholders are at the front of the line to get paid. This means that VCs can recover their invested capital before common shareholders see any returns, significantly lowering their financial risk in the investment.
Anti-Dilution Protection: These provisions safeguard VCs from losing too much of their ownership percentage in the company during future fundraising rounds. Maintaining a larger share ensures that VCs keep their voting power and influence over company decisions, which is crucial for their long-term strategic interests. Both liquidation preferences and anti-dilution provisions become very, very important if a company is having a downround (read our guide to downrounds here).
Information Rights: VCs often secure information rights as part of their investment in preferred stock. These rights grant them access to detailed financial reports, strategic plans, and other critical company information. This level of transparency ensures that VCs have a thorough understanding of the company’s performance and prospects, enabling more informed decision-making and closer oversight of their investment.
Voting as a Class to Block Major Decisions: Perhaps one of the most significant powers that come with preferred stock is the ability to vote as a class on crucial decisions. This can include blocking or approving major corporate actions like the sale of the company. Such a provision allows VCs to protect their investment by having a significant say in decisions that could fundamentally change the company’s direction or value.
Other advantages include pre-emptive rights, repurchase rights, drag-along and tag-along rights, and more. So again, work with an experienced lawyer!
When startups receive VC funding the expectations on the company’s books become much, much higher. Professional investors expect quality accounting that helps them make decisions on how the business is doing. For handling the accounting of preferred stock, there are mainly two ways to go about it. First, there’s the GAAP Method. It’s the standard way and pretty thorough, but it can get a bit too complicated for startups, and in our opinion is overkill. Most investors at the earliest stages do not require this, and the expense and time required is usually not worth the investment. Then, there’s the Investor-Preferred Method, which is more about keeping things straightforward, simple, and easy to understand - which usually sits well with investors.
One item that is particularly confusing is how the fundraising costs are recorded. These generally are capitalized on the balance sheet, which means that they do not flow through the income statement. Make sure you get this right, and are able to answer questions if your VCs have them.
Kruze is a recognized expert on startup accounting. Reach out to us if you need help managing your company’s books, taxes and finances!
Important Tax Dates for Startups