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.
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.
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:
Discounts on conversions can significantly affect a startup’s capital structure and valuation. Here’s what founders need to consider:
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.
Founders should be aware of the various rights attached to preferred shares, as these can significantly impact the company’s future:
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!
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.
When considering preferred share investments, founders must balance the needs of the company with investor expectations. It’s crucial to:
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.
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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