Investors generally receive some form of equity interest in a company in exchange for their capital financial investment. An investor might receive common stock, which is the same stock held by company founders. This is rare except in cases where friends and family make an early seed-capital investment. In some cases, the investor will receive a debt instrument that can later be converted to equity. In other situations, the investor will receive an option or warrant to purchase an equity investment at some point in the future. These arrangements are very common in early seed-stage investments. Later stage investors almost always receive a class of preferred stock. The company will authorize a specific class of preferred shares for each round of equity investment.
In this article we discuss the various characteristics of the issuance of preferred stock to investors of startup companies.
Common Characteristics of Preferred Shares
Preferred shares can take on any number of characteristics. Each attribute of the preferred shares is used to either protect the investors or the company. The most common attributes of preferred stock are as follows:
- Conversion Rights – Conversion rights allow the holder of the preferred shares the opportunity to convert those shares into common shares. This allows the shareholder to take advantage of whichever form of equity investment is most valuable. The reason common shares may be more valuable has to do with the other protective provisions characteristic of preferred shares. Likewise, the company may require conversion of the preferred shares in certain specified scenarios, such as the company being sold or going through a public offering.
- Liquidation Preference – Most preferred shareholder receive some form of liquidation preference. This means that the investor receives a return of her investment capital (or some multiple of the amount invested) before other shareholders receive any funds from the sale of the the company. This protects the investor from a scenario where she invests money in the company and the company is subsequently sold at a lower valuation.
- Participation Rights – Preferred investors often receive participation rights in distributions from the sale of the company. As discussed, the preferred investor will generally receive some multiple of her initial investment before other shareholders receive any distribution. Once the liquidation preference is paid, other shareholders may receive the remainder of the funds from the sale of the company. If, however, the preferred shareholder has participation rights, she will share in any additional distribution to shareholders, based upon their ownership percentage. The other shareholders are generally allowed to “catch up” or receive a distribution equal to that of the preferred shareholder before the preferred shareholder receives any more funds. The rights of the preferred shareholder to participate in proceeds is generally “capped” at a specific amount. Another above this amount goes to the other shareholders. If the company sells for a very high valuation, it could mean that the stock of other shareholders is more valuable than the preferred shares, even in light of the preferred shareholder’s liquidation preference. This is the reason the preferred shareholder may be better off converting her preferred shares to an equal percentage of common shares.
- Redemption Rights – This concerns the right or obligation of the company to repurchase the stock of shareholders in certain circumstances. Demand provisions protect the preferred shareholder by giving her the option of selling the shares back to the company under certain circumstances. Mandatory redemption requires the company to repurchase the preferred equity in certain circumstances, such as the sale of the company or a public offering. This protects the company from being held up in a transaction by an individual shareholder.
- Registration Rights – This allows the investor to force the business to file a registration statement with the Securities and Exchange Commission (SEC) indicating an intent to sell the stock to the public. These are known as “demand rights”. These provisions might also allow the investor to take part in any registration of securities with the SEC, known as “piggy-back rights”.
- Pay-to-play provisions – These provisions incentivize investors to take part in future rounds of financing. They require that an investor invest in future equity rounds at an amount equivalent to their percentage of equity investment in the business to avoid dilution and potential loss of preferential rights.
- Preemption rights – These provisions generally grant the company the right of first refusal to purchase shares being offered for sale by the preferred shareholder. This allows the company to keep control of the stock in the event a shareholder wants to sell her shares or cash out.
- Co-Sale rights – This provision allows the preferred shareholder to sell her shares alongside any founders who decide to sell their shares. This prevents founders from selling their equity interest and leaving the equity investor still holding their shares.
- Anti-dilution Measures – When a company issues a later round of equity at a lower valuation, this can cause the interests of the preferred shareholder to be diluted. The preferred shareholder may receive full-ratchet or weighted-average anti-dilution protections.
- Voting rights – This provision might provide the preferred shareholder the right to participate in voting along-side common shareholders.
- Protective rights – These provisions require voting approval by a class of preferred shareholder for certain events, such as pursuing an exit event.
- Dedicated Board Seats – Investors may also require a control provision identifying specific board seats for themselves or their chosen representatives.
- Information rights – This provides greater rights to information an oversight of company actions by the investor.
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