Common stock is the basic type of share of corporate ownership. Corporations frequently authorize and grant a special class of stock, known as “preferred stock”. Preferred stock, or preferred shares. as the name implies, grants preferential treatment or status to the holder. Generally, preferred stock and preferred shares are authorized and distributed as part of an investment round. Subsequent investment rounds may involve a different type or separate series of preferred stock. As such, it is not uncommon for a startup company to issue multiple classes of preferred stock and preferred shares throughout its lifecycle. It is worth mentioning that the various forms of preferred stock are often repurchased or redeemed by the company prior to subsequent funding rounds or prior to the company undergoing an initial public offering.
Characteristics of Preferred Stock
Preferred shares must be specifically authorized in the articles of incorporation. They will have various characteristics that are specifically negotiated between the investor and the company directors. These characteristics will be recorded in the stock grant, bylaws, and as part of shareholder agreements between the investor and company. The most common characteristics of preferred shares are as follows:
- Conversion Rights – These rights all the preferred shareholder to convert her shares of preferred stock into common stock. Further, it may require the shareholder to convert the shares in specific circumstances, such as undergoing a public offering.
- Liquidation Preference – The liquidation preference allows the preferred shareholder to receive some multiple of the stock purchase price upon sale of the company. The shareholder receives these funds before other shareholders receive any distribution of funds.
- Participation Rights – Participation rights allow the preferred shareholder to receive a percentage of profits from sale of the company. Once the shareholder receives her liquidation preference, other shareholders are allowed to catch up. That is, they are allowed to receive a commensurate distribution (based upon the shareholder’s ownership percentage). If there are additional funds remaining after the distribution to all shareholders, the preferred shareholder receives a percentage of those funds based upon her ownership percentage. She is “participating” with other shareholders in the distribution. The amount to which the preferred shareholder is entitled to participate is often “capped”. For this reason, it may be advantageous for the preferred shareholder to convert her preferred shares to common shares.
- Redemption Rights – Redemption rights allow the shareholder to force the company to repurchase her shares upon specified occurrences. This is known as “voluntary redemption”. The rights may specify circumstances under which the company is required to purchase the shareholder’s shares. This is known as “mandatory redemption”.
- Registration Rights – Registration rights allow the shareholder to force the company to register the preferred shares with the Securities and Exchange Commission. This provides liquidity to the preferred shares, as the shareholder can now sell the shares openly to the public. These are known as “demand rights”. “Piggy-back rights” allow the shareholder to take part in any registration of existing company shares. This would be the case if the company registered a separate class of shares.
- Pay-to-play provisions – These rights allow the shareholder to invest in future rounds of company financing. This protects the shareholder from having her ownership percentage diluted by future financing rounds.
- Preemption rights – These rights allows the company or other shareholder the right of first refusal to purchase the preferred shares if the preferred shareholder decides to sell or transfer those shares.
- Co-Sale rights – This allows the preferred shareholder to sell and equal percentage of their shares if another shareholder decides to sell her shares.
- Anti-dilution Measures – These are special provisions that change the conversion formulas of the preferred shares to common shares. It protects the preferred shareholder’s interest from dilution if the company undergoes future rounds of equity financing at a lower company valuation.
- Voting rights – These rights might allow the preferred shareholder to vote her shares. It could even grant super voting rights, such as multiple votes per share of preferred shares.
- Protective rights – These allow the preferred shareholders the right to approve or disapprove specific company actions.
- Dedicated Board Seats – The preferred shareholders may have the opportunity to vote for or elect specific seats to the board of directors.
Information rights – Information rights concern the nature or extent of access a shareholder has to company information.
The Process for a Stock Grant
A company must undertake several steps in order to grant stock. The primary steps are as follows:
- Board Approval – The board of directors must approve any stock grant or stock distribution. The articles bylaws generally state the percentage of directors needed to approve the distribution.
- Authorization – The company must specifically authorize the class of preferred shares within the articles of organization. This generally requires amendment and restatement of the articles.
- Stock Purchase/Grant Agreement – The company will employ a contract known as a stock purchase agreement to distribute the shares to the investors. It is sometimes referred to as a “subscription agreement”. This contract will contain specific terms of the stock purchase agreement.
- Securities Compliance – The issuance of stock must first be registered with the Securities and Exchange Commission (SEC). Generally, the company will perfect an exemption from registration under Regulation A or D.
LawTrades Knows Stock Grants
Distributing equity to investors is a complicated undertaking. It requires multiple considerations including: tax considerations, securities filings, contract provisions, and corporate governance procedures. The legal professionals at LawTrades are experts in company equity distributions. Let us help you through this process.