Preferred Stock 101
Navigating Preferred Share VC Rounds: A Guide for Startup Founders
Chief Operating Officer
Founder & CEO
As experienced CPAs and CFOs serving the startup ecosystem, we’ve seen firsthand how preferred stock - and the VCs who own that preferred - can shape a company’s journey. These investments are a vital tool for startups seeking funding, but they come with complexities that require careful navigation. Here’s our guide to help founders understand and effectively manage these investments.
Price Rounds - When Preferred First Hits the Cap Table
Preferred stock is the most common (side note, probably shouldn’t say “common” since that might imply common stock - let’s say “typical!”) security VCs purchase in a “priced round.” A priced round is when a company officially has a valuation attached, vs. many seed/preseed rounds where a convertible instrument like a SAFE or Convertible Note is purchased by investors.
Picking a valuation is a big deal - you can read our startup valuations article - and preferred holders purchase their stock at a negotiated stock price. That price is influenced by the conversion of SAFEs and Converts, and also by the addition of options.
The Role of SAFEs and Convertible Notes
In early-stage financing, SAFEs and Convertible Notes are popular instruments used by startups to raise capital quickly and with fewer upfront negotiations. The biggest avoided negotiation being that they don’t have an actual valuation, although they may have valuation caps. Here’s how they tie into preferred shares:
- Conversion into Preferred Shares: Both SAFEs and Convertible Notes are designed to convert into preferred shares at a later stage, typically during a priced equity round (like a Series A funding round). This conversion is often triggered by specific events such as a subsequent funding round or an IPO.
- Discounts on Conversion: To incentivize early investors, these instruments often include a discount on the price per share when they convert into preferred stock. For instance, if the discount is 20%, and the price per share during the equity round is $1.00, early investors convert their investment into preferred shares at $0.80 per share.
Impact of Discounts on Company Valuation and Preferred Stock Prices
Discounts on conversions can significantly affect a startup’s capital structure and valuation. Here’s what founders need to consider:
- Dilution of Ownership: As early investors convert their investments into preferred shares at a discounted rate, founders might face more dilution than anticipated. It’s important to calculate this potential dilution in advance to understand its impact on ownership percentages.
- Valuation Considerations: The conversion terms set in SAFEs and Convertible Notes, including the discount rate, need careful consideration. They directly influence the valuation at which these instruments convert into equity, impacting both the company’s valuation and the cost of raising capital.
- Preferred Stock Price Impact: The discounted conversion rate affects the price per share of the preferred stock issued during the conversion. This means the effective price per share for early investors (who hold SAFEs or Convertible Notes) will be lower than that paid by investors in the priced round. This discount must be factored into the company’s financial planning as it influences the amount of equity given to early investors and the remaining equity pool available for future financing rounds or for distribution among founders and employees. This is actually an iterative model - the conversion impacts the preferred stock price, which impacts the valuation, which impacts the conversion rate… again, work with a good attorney. And as CPAs serving startups, we have reviewed these cap table models for our founders numerous times.
Understanding Preferred Shares
In the startup world, preferred shares are a form of equity that combines features of both debt and equity. They offer investors ownership in the startup, with terms negotiated between the company and the investors. These shares usually come with a set of rights that differ from common shares, providing investors with both upside potential and downside protection.
Key Rights and Terms
Founders should be aware of the various rights attached to preferred shares, as these can significantly impact the company’s future:
- Board Composition: Preferred shareholders often have a say in the composition of the company’s board, influencing key decision-making processes.
- Liquidation Preference: These preferences ensure that preferred shareholders are paid out in liquidation scenarios before common shareholders. This is very, very important when a company exits for less capital than it has raised, or when it sells for less than it’s last valuation.
- Conversion Rights: This allows preferred shares to be converted into common shares, typically in situations like an IPO, impacting the overall equity structure.
- Protective Provisions and Voting Rights: These can give investors significant control over company decisions and protect their interests.
- Anti-Dilution Provisions: Protect investors from dilution in future funding rounds, ensuring their investment retains value. These matter a lot when there is a downround.
Of course, those are not all of the advantages and special rights that VCs get. Founders raising venture funding need to work with an experienced attorney, one who has done a number of venture rounds!
The Appeal to Investors
Preferred shares are attractive to investors like VCs and early-stage investors because they provide a balance of risk and reward. The rights associated with these shares offer protection against the high risks inherent in startup investing, while also allowing for significant upside potential.
What Founders Need to Consider
When considering preferred share investments, founders must balance the needs of the company with investor expectations. It’s crucial to:
- Understand the Impact on Ownership and Control: Assess how these shares will affect your control over the company and the distribution of future profits.
- Negotiate Terms Wisely: Work with experienced attorneys to negotiate terms that are favorable yet fair to both parties.
- Consider the Long-Term Implications: Evaluate how these terms will impact future fundraising and the company’s valuation.
- Be Prepared for Diligence: Investors will expect thorough and accurate financial information. Ensure your accounting practices are up to par.
- Realize Valuation isn’t Everything: Some investors - in particular later stage ones - will trade a higher valuation for more difficult terms. Founders really need to understand what they are giving away if they let VCs take onerous terms in exchange for a higher valuation - again, work with a great lawyer.
- Actively Manage the Cap Table: In addition to using a great cap table software, founders need to actively manage their cap table. This includes only letting important, strategic, helpful investors invest (if possible!) and making sure the option pool is well managed. VCs will diligence your cap table - it’s an important part of finance due diligence, so get it right and use a software to manage it (with your lawyers help!).
FOUNDER PREFERRED STOCK: A NEW TREND
Founder preferred stock represents a recent innovation in the startup landscape. Traditionally, founders received common stock, and founders could secure capital gains and benefit from the company’s growth. However, a new trend has emerged: founder-preferred stock.
In this model, some founders are now receiving a portion, usually around 10% – 20%, of their usual common stock allocation in the form of founder preferred stock. This unique class of stock converts to preferred stock when founders sell it to investors during a subsequent round of financing. Founder preferred stock is granted with full vesting upon issuance and is not subject to repurchase or forfeiture if the founder departs from the company.
NOTE: We’re not Issuing official tax advice on this new trend. You need to work with your legal counsel if you’re considering founder preferred stock.
Final Thoughts
Convertible preferred share investments are a double-edged sword: they offer vital funding but come with strings attached. Founders must approach these investments with a clear understanding of the terms and a long-term strategy for their company. As experienced CPAs and CFOs in the startup space, we emphasize the importance of seeking professional advice and conducting thorough due diligence to ensure these investments align with your startup’s goals and values.
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