Basics of Preferred Stock
Since venture capital funds are usually precluded from investing in S Corporations, partnerships and LLCs by tax restrictions on their investors, they usually receive C corporation preferred stock in return for their investments.
Preferred stock issued to venture capitalists is different than the preferred stock issued by publicly traded companies. Venture capitalist preferred stock has a liquidation preference. It has a dividend preference though start-ups rarely declare one. It is almost always converted to common stock and usually at the initial public offering or successful sale of the company. It is convertible at any time and automatically converts at certain events. It has voting power as if it were common stock and may have special voting privileges. It rarely has a redemption provision that allows the company to buy it back at a specified price in the future.
Numerous other features have been added to preferred stock issued to VC’s to bolster the argument that it was more valuable than common stock for tax purposes and allow common stock to be issued to founders and employees at lower prices than the preferred stock. Features were also added to minimize the loss to VC investors in case the company had problems.
A liquidation preference pays preferred shareholders some amount of money before the common shareholders if the company liquidates. Typically, the liquidation preference will be set to a multiple of the amount initially paid for the stock. If, for example, that multiple is 2, a preferred investor had initially invested $3 million for 60% of the company, then the first $6 million distributed to shareholder would go to the preferred shareholders and the rest would go to the common shareholders.
A liquidation preference will usually add accrued and unpaid dividends though very few start-ups pay dividends. However, some arrangements will have a “cumulative dividend” that is a mandatory annual dividend designed to build up value of the liquidation preference over time. Other arrangements will mandate the the liquidation preference goes up by some rate every year.
“Participating preferred stock” allows the holder of preferred stock to receive the amount they initially invested before the common shareholders and then receive a pro rata share of what’s left after the liquidation preference is paid.
If the company issues multiple rounds of preferred stock, then it needs to decide whether the earlier series of preferred stock get a liquidation preference over the others or whether they are treated equally or “in pari passu”.
Preferred stock may also have a dividend payment set at some rate if the directors declare a dividend. Since start-ups rarely declare dividends, this provision is used mostly to boost the argument that preferred stock is more valuable than common stock for tax purposes and to allow the founders to purchase common stock at a lower price.
Redemption rights allow the holder to force a company to buy back stock sometime in the future. Investors usually request redemption rights to ensure that they can get some liquidity from the company if it does not perform well.
Redemption rights might make it more difficult to raise future rounds of capital as latter round investors may be concerned that their investment funds may go to buy out the earlier investors rather than growing the company. Later investors might also ask for redemption rights if the first round investors have them.
A company can argue against granting redemption rights by pointing out that the board of directors will protect the liquidity rights of all shareholders. If a company has no money, a redemption right has very little value anyway.
If granting a redemption right is unavoidable, it is best to push the date as far as possible into the future. Additionally, spreading out the payment for a redemption right over two or three years will provide some protection to a company’s cash flow.
Another issue is the price of the stock at redemption. Venture capitalists will usually want the stock redeemed at its liquidation price plus any accumulated and unpaid dividends. If the purpose of redemption is to provide liquidity, however, the redemption price should be the fair market value of the stock at the time of redemption. If both sides cannot agree on what price is fair market value, a third party appraisal can be used to determine it.
Preferred stock holders in venture deals usually have the right to convert their preferred stock into common stock at any time. The preferred stock usually converts to common stock at a ratio determined by dividing the initial purchase price by the “conversion price”. At the beginning, the conversion price is equal to the purchase price of the preferred stock and usually converts on a one-to-one basis.
Preferred stock often automatically converts to common stock upon certain events. Such events are typically when the company makes its initial public offering or if a certain percentage of the preferred shares votes to convert. A company should try to get the preferred shares to convert as soon as possible to get rid of their special rights and streamline the balance sheet for the initial public offering.
Usually a vote by the majority or a supermajority of preferred shares will force an automatic conversion. An entrepreneur should seek a majority requirement or the smallest supermajority requirement possible.
Automatic conversion at the initial public offering usually requires the following: (1) It must be firmly underwritten. In other words, the underwriters must have committed to placing the entire offering. (2) The offering must raise a certain amount for the company. (3) The offering price must exceed a certain minimum such as four times the conversion price of the preferred stock.
When the preferred stock converts, the inherent rights associated with it cease to exist. Some contractual rights, such as registration rights that force the company register a shareholder’s stock, usually survive. Other rights like information rights (the right to receive certain ongoing company financial information) and preemptive rights (the right to buy stock the company issues) usually terminate upon the IPO.
Any equity issue to third persons is a potential dilution of the ownership interests of the current shareholders as it lowers the percentage of their ownership. All shareholders usually get protection from certain issuances. For example, all common shareholders would receive a pro rata share of a stock dividend.
Preferred stock usually receives antidilution protection against stock dividends, stock splits, reverse splits, and similar recapitalizations. Conversion prices are usually adjusted to ensure that the percentage of common stock to preferred stock stays constant.
Another type of antidilution protection is the “right of first refusal” or “preemptive right”. Under a right of first refusal, any shareholder has the right to purchase a pro rata share of any new stock issuances to maintain his or her level of ownership. This right is a contractual one that expires upon the IPO in most venture capital deals. It can also be a right attached to preferred stock as set forth in a certificate of incorporation. Under extreme forms of a preemptive right, a company must first offer all the shares to the current shareholders rather than just a pro rata share.
Some situations make a pro rata preemptive right inconvenient. Thus, typical exemptions to a preemptive agreement include stock issued to employees, directors, consultants, strategic partners, those leasing or lending money to the company and acquisition targets.
Waiting for the time to exercise a first refusal right to expire or getting waivers can take time and create problems in closing a deal. There are also reasons not to have a preemptive right. Having one might prevent the company from having enough stock to sell to later investors. Not having a preemptive right may encourage investors to maintain good relations with the company in order to get future offers to invest in the company. Finally, if a large shareholder exercises a preemptive right, it might force other investors to buy or risk losing control of the company.
Most venture deals will have an additional antidilution provision. “Price protection” gives the venture capitalist some protection against later rounds of financing that issue stock at a lower price than it paid.
The venture capitalist’s valuation is an educated guess and price protection allows the venture capitalist to make an adjustment should later rounds of financing prove the initial valuation incorrect. If the price in later rounds is lower, the venture capitalist receives additional stock to make up for the price difference.
“Full ratchet antidilution protection” allows a venture capitalist who has invested in earlier rounds at a higher price than other VC’s in later rounds to receive additional stock as if they had bought it at a lower price in the first round. The company would have to issue those additional shares.
Full ratchet is rarely used because it is widely viewed as unfair. Common shareholders suffer most of the dilution and the later investors end up with a smaller percentage of the company than they bargained for. Additionally, a full ratchet occurs regardless of how small the latter issuance is.
However, there are some circumstances where a full ratchet is appropriate. If a venture capitalist discovers that the company is overvalued and needs more cash sooner than expected, the company might give a 6-12 month ratchet to assure the VC that it does not need to get later rounds of financing at a lower price. Additionally, as insurance against some future event occurring or not, such as getting a patent, ratchet protection might protect the VC if more money needs to be raised. Investors in the mezzanine round concerned with overvaluation or the market window closing might also seek a limited period ratchet.
“Weighted average antidilution” is used in most venture deals. Weighted average uses the following mathematical formula to set the conversion price:
New Conversion Price = (Old Conversion Price) *
(Number of Outstanding Shares Before Issuance +
(Money Invested in Current Round / Old Conversion Price)) /
(Number of Outstanding Shares Before Issuance + Shares Issued in Current Round)
The weighted average formula adjusts the conversion price based on the relative amount of the company being sold at the lower price. Some variations to the formula exist and the most common variations involve counting options as either issued or un-issued stock. Shares reserved for granted options are often counted as already issued while those for options to be granted are not.
Certain issuances will be excluded from the antidilution provisions. Common stock or options for future additions to the management team or additional shares for current members usually are excluded. Stock options for employees are often excluded from the antidilution provisions as well along with rights to purchase stocks granted before the issuance of the preferred stock is also excluded.
A “pay to play” provision requires the preferred stock holder to buy its pro rata share in later down-priced rounds of financing in order to get any price and antidilution protection. If the preferred stock holder does not purchase its pro rata share then its shares are converted to another series of preferred stock that has no price protection. This provision is designed to encourage all investors to help the company in difficult times. Such provisions, however, are atypical.
A venture capitalist’s preferred stock usually votes as if it was common stock. Preferred and common shareholders vote together on most matters.
Preferred shareholders have some protective provisions that require a majority vote of their class. These provisions usually involve changing the certificate of incorporation in ways that affect the preferred shareholders’ rights, privileges and preferences such as liquidation preferences, issuing securities senior or equal to existing preferred stock and changing voting rights.
Some venture capitalists will ask for such protective provisions for each series of preferred stock with each series voting separately. A company should try to avoid such arrangements as it reduces its flexibility by increasing the chances that any one investor can block changes.
Provisions to prevent the redemption of stock is another protective provision. These prohibitions usually apply to sales of substantially all the company’s shares or assets, increases in the number of authorized number of shares or directors.
Preferred investors might add additional items that are usually in bank loan agreements for their approval only. Such items include investing in other businesses, forming subsidiaries, incurring a certain level of debt, making loans to others and expending a certain amount of capital. A company should vigorously resist these provisions as investors should trust the board of directors to make the right decisions.
The lead venture capitalist in a round of financing will generally expect a seat on the board of directors. If there are multiple rounds of financing or VC’s, there may not be enough board seats, the board might get too large or be dominated by financial investors.
In the first round, the founders will most likely be able to retain control of the board. If there is only one VC in a round, it is common for it to request two board seats.
Founders and investors will usually have a written voting agreement or designate in the certificate of incorporation how many seats common shareholders can elect and how many preferred shareholders can elect. Consequently, control over the board can change as later rounds of financings occur.
An entrepreneur who wants to use the board as a source of advice might limit the board to a couple of seats for the founder, a couple for the investors and a couple for industry leaders agreed upon by both the founders and venture capitalists. This composition should keep the board focused on the company’s best interests rather than who controls the board.
Some venture capitalists will require a company to reach certain goals, also known as milestones, within a specified period of time. Such milestones might include reaching certain points in research or revenue levels. In some cases, reaching a milestone will trigger an obligation by a venture capitalist to invest more money. Failing to reach a milestone, on the other hand, might allow a VC to purchase more shares at a lower price.
A company should resist milestones that result in a change in control. There is risk in every business and should those risks, or the unexpected, occur, a company’s shareholders should close ranks rather than fighting over control. Milestones that trigger ownership changes place the founders and investors in opposition to each other. Additionally, milestones may force an entrepreneur to focus too much attention on them rather than the business’ best interests.
Wishing you success,
John B. Vinturella, Ph.D.
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